The writer is a professor of economics and public policy at Harvard university and former chief economist at the IMF
Is a modest burst of post-pandemic inflation necessarily a bad thing? With the US experiencing brisk inflation (5.4 per cent in the 12 months ending in June) there is growing talk of an inflation Armageddon if the Federal Reserve falls too far behind the curve. There are real risks. But maybe after a decade of below-target inflation, a few years of it being mildly above target, say 3 per cent, might be positively a good thing.
US inflation today is much more like good news than bad. Prices are rising mainly because the US economy is doing vastly better than seemed possible a year ago — thanks to early and aggressive US vaccine procurement, continuing huge macroeconomic support and a surprisingly successful shift to remote work.
The fact there are all kinds of temporary bottlenecks is hardly shocking. Last year, Hertz, the car rental company, declared bankruptcy; this year, with people wanting to travel again, rental car rates have soared. With quarantine over, everyone suddenly wants tradespeople to come inside their homes to do repairs and to make improvements. There are extremely long wait times for refrigerators and washing machines, even as their prices have risen considerably. The job market is tight, wage growth is strong and it is probably getting stronger.
Would we feel better if the economy were much weaker and inflation were lower? Sustained inflation may be a risk as the economy is dug out of its deepest hole since the Great Depression. But an unexpected setback in the fight against the pandemic is a bigger risk.
In much of the US, there is a palpable feeling that the pandemic is over. But that is a very parochial view. True, in the US, pretty much everyone who wanted to be fully vaccinated has been able to do so; the vast majority of the unvaccinated simply chose not to be. (Don’t ask me why.) Yet the pandemic is far from over. The two-thirds of the world’s population that don’t live in an advanced economy or China are in terrible straits. They can only wish that their biggest worry was inflation — although in countries such as Argentina, inflation is also out of control.
In 2008, as the financial crisis unfolded, I argued emphatically that central banks should relax their 2 per cent inflation targets and aim temporarily for 4 to 6 per cent inflation for a few years. Had they moved quickly and adopted effective negative interest rate policies, I believe that would have been possible. Higher inflation for a few years would have helped stimulate demand and taken the edge off many countries’ unsustainable debt burdens. (An alternative, first-best policy would have been to write down subprime mortgage debts in the US, and make unconditional transfers from northern Europe to pay for public debt writedowns in periphery countries such as Greece and Portugal.
Today, the situation is different. Because the US Treasury and the Fed stepped in so quickly and proactively, there were actually fewer corporate bankruptcies in 2020 than in 2019. Given that bankruptcies normally rise sharply in recessions, this admittedly sounds a bit like too much good news.
But even with debt problems contained, there are still benefits from temporarily higher inflation. The most important is that the Fed needs to allow above-target inflation occasionally — if it is serious when it says it targets 2 per cent as an average. Many had begun to wonder if that was even possible. After the inflation drought of the past decade, a mild downpour is welcome. Making the Fed’s target inflation more credible should help shift up the term structure of interest rates and give the Fed more room to cut them in future.
In fact, economic theory gives very little robust guidance on whether, say, 3 per cent inflation is better than 2 per cent in normal times, so long as it remains reasonably stable and predictable. When Olivier Blanchard was IMF chief economist in 2010, he argued that inflation targets should be raised to 4 per cent.
Sustained inflation of, say, 3 per cent would also offer an opportunity to reconsider the Fed’s current 2 per cent target. This is hardly a radical idea: a few central banks such as Australia and Hungary already have a higher inflation target and others such as the Bank of Canada have considered the idea. True, as I have long argued, a far more elegant way to give central banks greater room to cut in a deep recession is to lay the groundwork properly for unconstrained negative rate policy, but I leave that to another day.
I have emphasised the positive aspects of moderately higher inflation for a few years. But there are risks. The biggest is if the open-ended expansion of government spending and transfers is not substantially (it need not be fully) offset by higher taxes. If the global cost of borrowing should rise unexpectedly, the higher cost of servicing the bigger debt load could lead to government pressure on the central bank to keep nominal rates down — risking inflation that eventually becomes severe.
For the moment, markets seem thoroughly unconcerned — almost too much so given the pervasive uncertainty around the global economy as it emerges from the pandemic. Still, at least for now, mildly elevated inflation more likely signals that things are going well than that we are doomed. There is no reason for the Fed to squash it too quickly.