Fed Policy On Inflation: As Good as It Gets

Scott Sumner argues that the Federal Reserve erred in not expanding the money supply even more than it did last fall, and that monetary policy caused the financial crisis to worsen and our economic crisis to deepen. He suggests that a two percent inflation rate would be superior to the current rate, which is about zero. And he believes the Fed should further expand the money supply in order to increase the rate of inflation.

I respectfully disagree with him on all three points.

The Fed acted aggressively and correctly

Sumner argues that the Fed didn't do enough to expand the money supply. But it did an enormous amount. Bank reserves have increased from about $40 billion last summer, when the financial system began to weaken, to $900 billion today. And the banking system, which took on far too much risk, is in significantly better shape today because of this Fed expansion. Interest rates -- particularly on risky securities -- have declined, business and mortgage lending are back up around the levels of last summer, and a complete meltdown of the financial system has been averted. The Fed has successfully walked a tightrope between delivering enormous monetary expansion without triggering significant inflation, such as we had in the 1970s.

Two percent inflation would do little
But suppose the Fed did even more and raised inflation to two percent? Slightly higher inflation transfers a small amount of wealth from creditors to borrowers, but I don't expect this would make a significant difference in economic performance. And if inflation was slightly higher, housing prices would be a bit higher as well, as would the values of mortgage-backed securities. Sounds good so far.

But if financial markets were convinced that inflation was higher, mortgage rates would adjust to build in a two percent inflation premium. That would negatively impact homeowners -- particularly those whose mortgages are soon to reset -- and would also depress housing prices and mortgage-backed securities. It's hard to say what the net effect of these opposing forces would be, but it's also hard to see how a small change in inflation would do very much to expand the economy.

Sumner states that higher inflation would lead to higher employment, because it would reduce the real value of wages. But given the sharp drop in demand that many businesses are facing, a two percent inflation rate wouldn't make enough of a difference, in most cases, for a business to keep a worker versus laying him or her off.

It is true that one reason the Great Depression was so severe is that wages at that time were not responsive to deflation. But at that time, economic policies were explicitly designed to prevent wages from adjusting. They were set under the badly mistaken view that maintaining wage levels in the face of deflation would help maintain prosperity. Economics has progressed enormously since the 1930s, and policies like that are no longer in place today. As I noted in my previous post, wages today are indeed adjusting to current economic conditions.

In my view, a small increase in inflation would not do much. Our problems now have more to do with a regulatory system that gave financial institutions too much incentive to take on enormous risks. Restoring prosperity and increasing employment requires re-formulating these policies and getting incentives right. Economists have found that predicting inflation is notoriously difficult, but with that caveat in mind, it is reasonable to expect slightly positive inflation over the coming months. Any deflationary shocks would likely be met by a significant policy response by the Fed.

Follow Blog War on the inflation-versus-deflation debate:

• Scott Sumner, 6/26: Deflation is Our Biggest Problem -- Not Inflation
• Lee Ohanian, 6/29: The Fed Fears Deflation More Than Inflation
• Scott Sumner, 6/30: The Fed's Monetary Policy Has Veered Off Course
• Lee Ohanian, 7/1: Fed Policy on Inflation: As Good As It Gets
• Scott Sumner, 7/2: We Need Inflation to Spur a Recovery
• Lee Ohanian, 7/3: No, Inflation is Not the Key to This Recovery