Monday, September 26, 2011

The Inflation Debate

One of the ways of handling the Euro (and US) debt crises is slowly coming into focus – inflate it away. Since public debt is denominated largely in nominal historical terms, but public revenue is paid in current terms, inflation effectively reduces the debt burden. It’s an inequitable solution because it favours debtors over creditors, but it has traditionally been one of the main avenues for public debt relief – about half the reduction in the debt to GDP ratio after WWII was due to inflation (the other half from growth).

Since growth is obviously going to be lacking in developed countries over the near future, the inflation weapon is slowly moving into mainstream discussion:

Higher Inflation: Scourge or Savior?
The Federal Reserve and other central banks ponder benefits of higher prices

With consumer prices up 3.8 percent in the 12 months through August, you might think the Federal Reserve’s rate-setting committee would be taking stern action to lower inflation. Far from it. On Sept. 21 the Federal Open Market Committee announced it would make monetary policy even looser through what economists have dubbed “Operation Twist”—switching $400 billion worth of its Treasury holdings from short-term securities into long-term ones in a bid to bring down long-term interest rates.

High inflation isn’t the main risk, the rate setters said; weak growth is. The FOMC statement said the committee anticipates that inflation will wind up at or below its target range rather than above it in coming quarters “as the effects of past energy and other commodity price increases dissipate further.” The Fed’s implicit inflation target is 1.7 percent to 2 percent.

The Fed isn’t the only central bank that seems to be putting inflation worries on the back burner while fighting slow growth. The Bank of England has held its key rate at a record low even as U.K. inflation breached its 2 percent target for 21 months. Brazil executed a surprise cut on Aug. 31 to preserve growth even after inflation quickened to a six-year high.

David Beckworth shows how this could work in Europe:

The Geithner Plan to Save Europe is Not Enough

...Here is how. If the ECB were to sufficiently ease monetary policy, it would cause inflation to rise more in those parts of the Eurozone where there is less excess capacity and nominal spending is more robust. Currently, that would be the core countries, particularly Germany. Consequently, the price level would increase more in Germany than in the troubled countries on the Eurozone periphery. Goods and services from the periphery then would be relatively cheaper. Therefore, even though the fixed exchange rate among them would not change, there would be a relative change in their price levels. This would provide the much needed real depreciation for the Eurozone periphery as they move forward in their attempts to salvage their economies.

The IMF has already gone on record as saying the idea has some merit.

Here’s the other side of the argument, from Raghuram Rajan:

Is Inflation the Answer?

…To understand the prescription, we have to understand the diagnosis...The key questions are: Can central banks generate sharply higher inflation for while? Will it work as advertised? What could be the unintended consequences? Are there better alternatives?

Start first with whether central banks with anti-inflation credibility can generate sharply higher inflation in an environment of low rates. Japan tried and failed...

…Moreover, the central bank needs a rapid sizeable inflation to bring down real debt values quickly -- a slow increase in inflation (especially if well signaled by the central bank) will have very limited effect because maturing debt will demand not only higher nominal rates but also an inflation risk premium to roll over claims. But a sizeable inflation may be hard to contain, especially if the central bank loses credibility…

…Turn next to whether it will work as advertised. Inflation will do little for entities with floating rate liabilities…or relatively short term liabilities (banks). Even the U.S. government, with debt duration of about 4 years, is unlikely to benefit much from a surprise inflation, unless it is huge. Meanwhile the bulk of its promises are social security and healthcare that cannot be inflated away...

Of course, any windfall to borrowers has to come from someone else’s wealth. Inflation will clearly make debt holders worse off...

...In sum, higher inflation might work as a solution, but there are many risks in trying it...For other debtors like banks and the government, though, it is not clear why they should not be forced to undertake the hard actions that will bring their debt under control.

My take? I think this is worth trying. My view of the 1970s is that the high inflation of the period was largely a structural adjustment to the cumulative misalignment between the value of goods and assets relative to money that occurred in the 1960s, a consequence of the rigid maintenance of the system of fixed exchange rates under the Bretton Woods system. The oil price shocks and monetary expansion just exacerbated the situation.

In addition, slow growth is already endemic in the developed world – there’s no solution to the debt problem from that quarter. Another point is that with nominal price and wage rigidities, the only way to adjust prices and wages towards a real economy full employment equilibrium without triggering depression sized unemployment and business retrenchment is again, through inflation – I’m no believer in classical general equilibrium where economies adjust automatically to full employment.

Fourth, and last point, even though interest rates in the developed world are low, they are still not low enough based on anaemic credit expansion and unemployment i.e. despite popular perception, current policy is still actually too tight. Higher inflation would effectively loosen monetary policy even if central banks do nothing else. The Fed doesn’t even have to print more money – all it has to do is abolish the policy of paying interest on excess reserves.

Obviously an inflation solution is not ideal, but I believe the social costs of pursuing this (an adjustment in nominal monetary terms) will probably be lower than the alternative (an adjustment in real economy terms), and would work faster to boot. The consequences of course are not costless – higher inflation inordinately affects the poor. And monetary expansion in the West will have consequences in the East (stronger exchange rates if nothing else, and the potential for asset bubbles).


  1. The trouble with inflation is that while you may put it in play, it is very difficult to take it out later. Of course one can easily say, well, we can just introduce "a little bit" of inflation but how this is controlled is never mentioned. There is always a lag time when you want to get inflation that is already out there under control. To inflate themselves out of the debt, there has to be sufficient credibility on the ECB and Fed's side. Otherwise, it can make things worse.

    But the real question right now is, is debt really the problem? The debt has always been there. There is nothing that is making it more urgent for the US. Eurozone yes, but definitely not for the US. Shouldn't the focus be on the 9% unemployment rate?

  2. Actually I think all it would take would be a firm commitment from the ECB and the Fed for a 4% inflation target, much like the implicit target of 2% that they have now (4% was the rate mentioned in the IMF report).

    But I agree, in the US case from a real economy perspective, the public debt level isn't an immediate concern. It is politically though.

    I'm also thinking in this context of boosting growth. Right now, a lot of money is on the sidelines. Raising inflation increases the cost of holding cash for investors, companies and households. It's probably a more effective loosening strategy than the past two QE exercises which attempted to lower credit costs directly.