Inflation isn't the enemy, and it needs to rise now

Conventional economic wisdom says low inflation is best. It maximizes the earnings power of middle-class Americans. It protects the purchasing power of savings. And it minimizes disruptions like constantly changing prices.

But a new line of thinking by many at the Federal Reserve and on Wall Street argues that in our current environment of tepid growth, high debt and ultra-low interest rates, higher inflation is the more desirable goal, at least over the short term. Specifically, that the Fed should increase its stated inflation target from 2 percent to something more.

Providing justification for this is the realization among many Fed officials that we could be in a “secular stagnation” scenario, in which the scars of the financial crisis and the side effects of the monetary methamphetamine used to end it have badly damaged economic vitality.

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As a result, the Fed has lowered what it believes the “neutral,” or balanced, short-term interest rate is from 4.25 percent a few years ago to just 3 percent now. A far cry from the 5.25 percent seen in 2006 and 2007 or the 6.5 percent seen in 2000.

The trouble is this lower rate makes the economy more vulnerable to recessions as well as lessening the Fed’s ability to cut interest rates to reinvigorate growth. According to Bank of America Merrill Lynch economist Ethan Harris, this increases the chances that we’ll see both inflation and the Fed’s policy interest rate fall into negative territory -- an exceedingly dangerous and never-before-seen situation in the U.S.

Harris notes that central banks -- not just the Fed but others as well -- have aggressively fought this this risk via increasingly unconventional policy strategies: Interest rates have been cut 667 times since Lehman Brothers collapsed. The Bank of Japan is buying equities. The European Central Bank is buying corporate bonds. Overall, central banks own $25 trillion in financial assets (larger than the economies of the U.S. and Japan combined).

But what hasn’t changed is the inflation target policymakers are shooting for.

Harris suggests that one possible solution would be for the Fed to raise its inflation target, even on a temporary basis, to send an unmistakable message to markets that it will do what it takes to end secular stagnation and avoid a nightmare debt-deflation scenario.

This thinking has reached the upper echelons of power, with Fed Chair Janet Yellen on Friday saying the Fed isn’t currently considering such a move, despite San Francisco Fed President John Williams arguing for one in a recent paper.  

This echoes a call for higher inflation the International Monetary Fund first made six years ago.

If the Fed were to announce that it would tolerate higher inflation, Harris believes the deflation risk (which makes debts harder to pay off) would be reduced, helping push interest rates back into normal territory.

If this seems like playing with fire writ large, well you aren’t exactly wrong. Out-of-control inflation -- as it was in the late 1970s and early 1980s -- is damaging in its own way. Yet as things stand now, the risk between inflation and deflation is asymmetrical. That is, deflation is the scarier and harder problem to fight.

So why not make a deal with the devil we know?

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.