David Pearson, a regular and very acute commenter on this blog, responded with the following comment to my recent post about the remarkable 1933 recovery triggered by FDR’s devaluation of the dollar a month after taking office.
Here is a chart [reproduced below] showing the 12-mo. change in a broad range of CPI components. IMO, FDR would have been quite happy with this performance following 1933. The question is, if the Fed eased to produce 4-5% inflation, as MM’s recommend, what would each of these components look like, and how would that affect l.t. household real wage growth expectations? In turn, what impact would that have on current real household spending?
I inferred from David’s comment and the chart to which he provided a link that he believes that recent inflation has been distorting relative prices, and that he worries that increasing inflation would amplify the relative-price distortions. I thought that it would be useful to track the selected components in this chart more than one year back, so I created another chart showing the average rate of change in the CPI and in the selected components from January 2008 to January 2010 along side the changes from January 2011 to January 2012. There seems to be some inverse correlation between the rate of price increase in a component in the 2008-10 period and the price increase in 2011. Of the 6 components that increased by less than 1% per year in the 2008-10 period, four increased in 2011 by 4.7% or more in 2011, the remaining components increasing by 4.4% or less in 2011. So the rapid increases in some components in 2011 may simply reflect a reversion to a more normal pattern of relative prices.
I agree that inflation is not neutral. There are relative price effects; some prices adjust faster than others, but I don’t think we know enough about the process of price adjustment in the real world to be able to say that overall inflation in conditions of high unemployment amplifies relative distortions. What we do know is that even after a pickup in inflation in 2011, inflation expectations remain low (though somewhat higher than last summer) and real interest rates are negative or nearly negative at up to a 10-year time horizon. Negative real interest rates are an expectational phenomenon, reflecting the extremely pessimistic outlook of investors. Increasing future price-level expectations is one way – I think the best way — to improve the investment outlook for businesses. We are in an expectational trap, not a liquidity trap, and an increase in price-level expectations would generate a cycle of increased investment and output and income and entrepreneurial optimism that will be self-sustaining. Say’s Law in action; supply creates its own demand.
In a more recent comment on the same post, David Pearson worries that insofar as inflation would tend to reduce real wages, it will cause wage earners and households to cut back on consumption, thereby counteracting any stimulus to investment by business from expectations of rising prices. To the extent that expectations of future wage growth fall, workers may also revise downward their reservation wages, so, even if David is right, the effect on employment is not clear. But I doubt that short-term changes in the inflation rate cause significant changes in expectations of future wage and income growth which are dependent on a variety of micro factors peculiar to individual workers and their own particular circumstances. As usual David makes a good argument for his point of view, but I am not persuaded. But then I don’t suppose that I have persuaded him either.