Why slightly higher inflation might benefit the U.S. economy

The U.S. Federal Reserve Board hasn’t hit its stated inflation target of two percent in more than four years, at least according to its preferred measure. One reason for this sluggish pace is the extraordinary decline in oil prices, but the Fed still isn’t seeing much process toward hitting its goal. So with the central bank’s benchmark Federal Funds interest rate at close to zero, perhaps it’s time to rethink that target rate. Why not aim for a higher inflation rate of, say, 4 percent, which would allow inflation-adjusted interest rates to go even further below zero  to help boost economic growth during a possible future downturn.

One reason this could be a problem is that many models of the U.S. economy say that higher inflation would deliver big distortionary problems. One of the large potential costs, price dispersion, happens because, as Noah Smith of Bloomberg View puts it, “when companies want to change their prices but for some reason can’t, inflation distorts prices from what they should be, which decreases economic efficiency.” A new working paper, however, looks at past experiences with these potential inflation-induced inefficiencies during a period of high inflation and find evidence that maybe there isn’t that much to fear.

Economists Emi Nakamura, Jon Steinsson, and Daniel Villar of Columbia University and Patrick Sun of the Federal Communications Commission built a brand new dataset on inflation before tackling a very important question on the costs of inflation. The economists painstakingly created a data set on individual price changes using old U.S. Bureau of Labor Statistics data. Creating these data allow the researchers to look at how prices changed during the late 1970s and early 1980s, an era of high inflation.

To look at how inflation could affect price setting and increase price dispersion, the four economists look at the absolute size of the price increase and its relationship to the pace of inflation. If prices are raised by a larger amount then price dispersion increases with inflation and therefore higher inflation would reduce efficiency. But what Nakamura, Steinsson, Sun, and Villar find is that the absolute price changes don’t vary that much regardless of the inflation rate. This means it doesn’t look like higher rates of inflation cause more price dispersion.

What the four economists do find is that price hikes happen more frequently when inflation is higher, which gives more credence to “menu-cost” models of price setting, or models where companies can’t easily change prices.  So if a major source of the cost of inflation in leading models doesn’t seem to show up in the data, perhaps economists and policymakers should rethink their devotion to near-zero inflation rates. Ten percent inflation is certainly too high, but a rate of 4 percent seems to have been consistent with steady economic performance in the past, such as in the 1980s, as well as provide more monetary policy firepower in an era of low interest rates.

(Photo by Charlie Neibergall, Associate Press)

August 16, 2016


Nick Bunker


Monetary Policy

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