No, Inflation Is Not the Key to This Recovery

Scott Sumner is a leading advocate of having the Fed increase inflation from its current rate of about zero to two percent. He forcefully argues that if this could be achieved, then our economy would improve substantially. But in my view, a small increase in inflation wouldn't improve economic performance very much at all.

Inflation's impact
Sumner argues that even a small change in inflation would have a large impact on our economy, because wages and the prices of goods and services don't adjust quickly to changes in demand. If they did, then employment and output wouldn't fall very much during declining inflation, or even modest deflation. The assumption behind Sumner's arguments is that wages and prices simply won't adjust.

My view contrasts with Sumner's in two ways. One is on our views about how fast wages and prices do adjust. As I noted in an earlier post, there is considerable evidence that wages are already adjusting to our economic crisis.

The other difference is how I view the impact of inflation on the economy. When inflation is high, borrowers repay loans in cheap dollars, which is a wealth transfer from creditors to debtors. With deflation, borrowers repay loans in dollars that are worth more. A small increase in inflation thus represents a small wealth transfer from creditors to borrowers.

Would our current crisis been less severe had inflation been two percent last year, rather than minus one percent? Not in my view. A two percent inflation rate wouldn't have saved the financial system from near implosion, nor would it have rescued the auto or construction industries. It is hard to imagine that what happened with Citibank, Lehman Brothers, Bear Stearns, Bank of America, Countrywide, GM, Chrysler, and so many others would have been much different if only inflation had been a bit higher. We dug ourselves into an economic hole that monetary policy cannot pull us out of.

Despite zero inflation, the outlook is brightening
Sumner believes that with zero inflation, unemployment will remain high and our current crisis will continue. Regarding the future course of inflation, as I noted in my previous post, it is remarkably difficult to forecast inflation. My research with Andrew Atkeson shows that the best indicator of future inflation is the current inflation rate, which is about zero now. But there are already signs that the economy may improve much faster than many anticipated. The stock market is up by about 35 percent since March, job loss is slowing, and the financial system is much improved. With any luck, recovery will begin before long, and inflation will remain low.

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