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Why 2 Percent Inflation? Why Not Zero? — King Banaian
As Jim notes, inflation figures have come out and, depending on which data you use, you might say inflation was 1.5%, 1.7% or something in between. We are told that this is below the Fed’s target of 2%.
Question: Why is a central bank that is told to maintain price stability choosing 2% as its goal? Why wouldn’t price stability mean stable prices, or zero inflation?
In Europe, the central bank uses a devices called the Harmonized Index of Consumer Prices, and aims for its rate of growth (or inflation rate) to be “below, but close to, 2% over the medium term.” In explaining its position, the European Central Bank cites three reasons for 2 over zero:
1. The risk of deflation. Monetary policy relies on interest rates to stimulate demand, but in a deflationary environment interest rates tend to move towards zero, making monetary policy ineffective. This is an odd concern for the ECB, as it has no responsibility for output growth, only for price stability. In the US case, there is more a need for protection from the zero bound: It is what lead to quantitative easing. Without QE, the Fed would have invited further expansion from fiscal policy, and perhaps more fundamental changes in the Fed’s charter — something we might want to avoid, given what we saw Congress do with Dodd-Frank.
2. No matter which measurement of inflation is used (HICP in Europe, core PCE deflator in the US), there is the risk that your measurement has errors. If you believe the cost of low inflation is less than the cost of low deflation, you might want to lean on the scale a bit to move the target inflation rate above zero.
3. Inflation isn’t the same in every part of a country or zone of countries. CPI in my part of the country — the Minneapolis-St. Paul area — was 1.9% in 2013. In Phoenix it was 1.3% for 2013, and 0.2% for the last six months. Yet we all have to work with one Federal Reserve. In Europe, the inflation rate in Greece differs from that in France, but they decided to stick themselves with one ECB. So you might want a few areas with a little more than 2%, others with a little less, but nobody (hopefully) with less than zero.
Notice that in each point above I included the words “might want.” There is disagreement among policy professionals about how much you “might want” — a debate that continues, sometimes even here at Ricochet. And it’s reasonable for people to disagree. You might argue that a small amount of deflation isn’t costly; others will disagree. Most economists believe that some rate slightly above zero is desired.
In my own view, the ECB’s phrasing of “below, but close to” is better than thinking you haven’t done enough if you get to 1.7% or 1.8%, because of the measurement issues, which I think are substantial. But it’s worth listening carefully to hear why an economist thinks inflation needs to be higher, or why it may already be too high.
Published in General
I just heard Larry Kudlow on the radio this morning support this view. I’m glad to know that at least one person with some expertise sees some value in it.
Agreed, except that I don’t see any reason not to widen the band just a bit to accommodate truly deflationary environments from time to time. Fixing things so that the economy always inflates seems an unnecessary fetter to a freer market. again, I’m not talking extremne deflation just as I understand you’re not talking about extreme inflation. We’re talking about a reasonable band.
I’m not sure that this thread is the place to explore the distinctions, so I’ll call for a truce on this until another time (and I do hope that this comes up again because I think it would be an interesting discussion).
If higher rates are explicitly a tool for killing inflation, then isn’t the corollary that lower rates are a tool for killing deflation?
Some prices have come down for sure, but overall inflation means that most prices rise and rise. Self correction would mean a deflationary period, wouldn’t it?
I’ve skimmed the thread, but I don’t think this has been posted.
I think the question of “why not zero inflation” is fascinating question. I got into a discussion a while back on this topic on another forum. I did some googling, and I found this article from the Economist on the “Perils of Falling Inflation” From my oversimplification, their key concern with inflation that is too low is it limits the ability of the government to manipulate the economy by lowering interest rates.
I agree with the comments that inflation is theft. It certainly is. With positive inflation, I need to invest my savings to minimize the loss of purchasing power, earning interest income, which is then taxed. So the government not only diminishes the value of my savings, but also takes a significant portion of the income that is solely generated by recovering the portion of the purchasing power that the government stole in the first place.
The ONLY upside to inflation I see is it discourages stuffing currency in your mattress, taking it out of the economy versus putting it in a bank. But to me, the downsides greatly outweigh the upsides.
I don’t know about this. It seems at least plausible that falling prices would increase demand. Would the promise of a 2% decrease next year be enough to delay consumption? That’s $2 savings on a $100 purchase. Sometimes (like maybe for automobile purchases), but I’d guess not often and certainly not indefinitely.
Agreed. I just misinterpreted comment #11.
Also agreed. Which is why I don’t understand why you support adjusting away any deflationary periods, to target modest inflation all the time.
I was not opining on the political expediency of a policy of inflation, I simply provided an example where there was significant deflation and prosperity ensued. Further, there does NOT have to be nominal wage cuts for deflation. Wages can remain steady or even increase but due to increases in productivity, the prices of goods fall. This has happened many times.
The key here is to understand expectations. If I can get the good next period for 2% less, and if the value of the good to me now versus next period doesn’t add 2% to my happiness (utility. satisfaction … you pick the word) then I wait. But if that 2% decline is expected to continue indefinitely it’s a very different calculation than a two-period analysis.
I have neglected in my description of the why-2%-not-0% argument the story of debt deflation, and the possibility of a deflationary trap. This is the Krugman story (which I am sure will turn off Ricochet readers) but, if you would, think about that story for Europe. The story dates back as far as Irving Fisher in 1933. If the Fed fears deleveraging, it has a fourth reason to worry about deflation, even a mild one for a short while.
I’d have to ask you for examples. Are these US examples pre-WWI?
I think you may be asking for some grand unifying theory of price stability that doesn’t exist. From a policy standpoint the preference is mostly just empirical: deflation has with very few exceptions been associated with depression. Mild inflation has a long track record of being associated with growth.
I understand the danger of too much deflation. But is the alternative too much inflation even if it’s spread out over decades?
Otherwise, even if I expect prices to decline indefinitely (by the way, responsible voices should do their best to disabuse people of this notion) I still have needs and wants right now. Am I going to put off a $100 purchase for two years to save $3.96? Three years to save $5.88? Unlikely, IMO. As I say, if I were buying a car for $25,000 then I might wait two years to save $900 depending on the need.
That and the fact that indefinite trends are an irrational expectation; the price might just go up at any time.
Besides, isn’t it possible that lower prices would be offset by higher demand?
Only if I expect prices to resume rising later. If I expect them to keep falling, I’ll put off buying until I just gotta have the thing–whether necessity or luxury. True enough, there are those who will buy now just to have cutting edge, but they’re not numerous enough to support an economy.
King has a related comment on this below (as I write; above as it’s posted…).
Eric Hines
No, I’m just asking that we stop comparing depression level deflation to mild inflation as if those are the only two possibilities. Obviously mild inflation is preferable to hyper deflation. But is mild deflation preferable to hyper inflation? I’d guess that it is.
Part, though not all, of the point of reducing the cost of capital is to stimulate consumption. But a significant part is to directly stimulate consumption.
Eric Hines
Probably, but the empirical case for this is slim to none post WWI/II.
I’d guess that those who will put off purchases indefinitely, chasing 2% decreases, are also not numerous enough to destroy an economy. It’s not as if the extremes are the only options available and I suspect that most of us would fall somewhere inbetween.
I’m not sure that this thread is the place to explore the distinctions, so I’ll call for a truce on this until another time….
I was using greed and self interest broadly–as was Gordon Gecko–but I agree that a separate thread for exploring the distinctions (and at some level there are important distinctions) would be both optimal and interesting.
Eric Hines
If higher rates are explicitly a tool for killing inflation, then isn’t the corollary that lower rates are a tool for killing deflation?
There isn’t always symmetry in the world. See this chart for the Great Depression for an illustration. Interest rates, even low ones, were largely irrelevant. The dominant factor was the expectation of continuing to fall prices leading to delayed consumption. This was heavily contaminated, though, by frequent, massive government intervention, including efforts to manipulate farm and labor prices, which greatly delayed any recovery from any source.
There are two ways to fight a deflationary environment: do nothing, (or nearly so, as the administration did in the Depression of 1920-21), or inject money directly into the economy faster over a short period than supply can absorb it. This latter isn’t optimal.
Eric Hines
…overall inflation means that most prices rise and rise. Self correction would mean a deflationary period, wouldn’t it?
No, the self correction would be a recession during which price rise rate–inflation–would fall. We’re stuck with the new price level in nominal terms, but the recession allows/forces adjustments to production and labor so that as an economy comes out of the recession, new growth continues, typically more steeply than in the period immediately prior to the recessionary period.
During the recession, real prices tend to stabilize or fall–something Big Green has been talking about–but it’s nominal pricing that sets expectations in us run-of-the-mill plebes who are the bulk of the economy. We’ll see those higher nominal prices, now not rising faster than normal, but production and labor costs–our wages–have caught up enough for growth–including prosperity growth–to resume.
Eric Hines
Part I: I understand the danger of too much deflation. But is the alternative too much inflation even if it’s spread out over decades?
Contra deflation, there’s no upper bound with inflation. In a mild inflationary regime, wages keep up, if laggingly so. And there’s technology evolution as a critical input that we’ve been…eliding…so far. My wife and I bought our first house some large number of years ago for $32k. We bought our current house 15 years ago for $180k. Some of that (nominal dollar) price rise was in the then-nascent housing bubble. But most of that rise was in the technology that went into the house, from city infrastructure supporting the house and neighborhood to construction techniques to goodies we had included to….
Technology advances work to reduce, in real terms, the price of most of the things we buy. In real terms, our present house may still cost more than that first one, but not by much. Wage growth plays a role, too, both in nominal and real terms. Our income 15 years ago was a whole lot greater than it was when we bought that first house.
Eric Hines
Part II: Our current house wasn’t even available all those long years ago, and the initial iterations of some of the technology advances in our current house were enormously expensive then.
With deflation, there’s a lower bound that’s a disaster. I’ve been over the expectations cycle in a deflationary period, and so has King. But there are necessities that we absolutely have to have: food, shelter, clothing in a northern clime. Selling prices cannot fall below the cost of production, or the thing won’t be produced at all.
At this low level, though, all we have is subsistence, and no one (but the very rich, who now may well be too few and too isolated to effectively influence the economy) has any money with which to buy more stuff–functionally to increase demand for goods.
Eric Hines
On expectations: Am I going to put off a $100 purchase for two years to save $3.96? Three years to save $5.88? Unlikely, IMO. As I say, if I were buying a car for $25,000 then I might wait two years to save $900 depending on the need.
You might not. Being the cheap b**rd that I am, I would. More importantly, though, the folks who are living pay check to pay check, if not hand to mouth will–they can afford to do no other. And they’re 40% of us–enough to tilt the economy.
Eric Hines
People living paycheck to paycheck still need things from paycheck to paycheck and they will still buy things in that timeframe; they’re not generally worrying about purchases that can be delayed, they’re worrying about purchases that can’t be delayed. Decreasing prices might just relieve some of their worry.
OK, but that lower limit is surely much lower than 2% and would require indefinite deflation. We have differing opinions on rational expectations and activity in a mild deflationary environment. That, and I see no reason why it needs to be anything other than mild and gradual giving people time to adjust, just as mild and gradual inflation gives people time to adjust and doesn’t automatically result in hyper inflation.
Thank you for the links.
May I jump in and ask a question? From what I’ve heard, Japan is still going through a long and sustained period deflation/stagnation (correct me if I’m wrong). Can this be directly tied, in part, to their diminishing and aging population or is that completely off base? If so, can their attempts at inflation be effective anyways or are they kind of doomed?
Japan has a number of things going wrong for it; a partial list includes these:
Yakuza–or the legal ones, keiretsu–keep major businesses too tied to each other to be very responsive to markets.
Japanese save “too much.” The population knows too well–historically, as well as just within the last 100 years–the price of having too little money; they’re very willing to delay consumption to be able to later.
They’re an aging population, with low birth rate; they know it. This puts premium on government preparing an even more robust social safety net than the one they already have and than even our homegrown liberals want for us.
They’re so long in deflationary environment–even though it’s quite mild–that they assume prices will continue to fall as completely as we assume our prices will continue to rise. This feeds into their penchant for saving and not consuming now.
They have no natural resources–their part of WWII was as much an attempt to secure critical resources as it was a naked power play. That lack makes them dependent on the outside world for their own well-being. Better save.
Eric Hines