Inflation ‘Cure’ Exposed

Inflation ‘Cure’ Exposed When In-Laws Move In: Caroline Baum

Commentary by Caroline Baum

(Bloomberg) -- When Ben Bernanke arrived at the Federal Reserve, first as a governor in 2002 and then as chairman in 2006, he was known as an inflation targeter.

He had written the book (literally) on the subject, based on his empirical research, and had come to believe -- at least until the financial crisis turned him into chief liquidity officer -- that adopting an explicit numerical inflation target is the best way for central banks to increase their credibility and achieve price stability.

Bernanke probably never dreamed he’d be asked to use inflation targeting to achieve higher prices. But that’s exactly what some respected economists are recommending, according to a May 19 Bloomberg News story. Harvard University’s Ken Rogoff and Greg Mankiw think more is better when it comes to inflation.

Rogoff said he advocates 6 percent inflation “for at least a couple of years.” That would alleviate the strain deflation imposes on debtors, including the U.S. government, who have to pay back their loans in appreciated dollars.

In the Middle Ages, they threw people who failed to repay their debts into debtors’ prisons. Today debtors are rewarded with all kinds of government perks. Look how far we’ve come!

Borrowers took out mortgages they couldn’t qualify for to buy homes they couldn’t afford. When the housing market collapsed, they were rewarded with government-subsidized mortgage modifications and, in some cases, partial forgiveness on their loan balances. And now, under Rogoff’s 6 percent solution, debtors would see more of their burden lifted.

And we, the savers, get screwed again.

‘Zimbabwe Solution’

How’s that for creating the wrong incentives? Retirees who worked and saved their whole lives and are living on fixed incomes can look forward to their dollars buying less in their old age. Those of you who are still working can make room for your mother-in-law, who is moving in tomorrow.

It’s hard to know exactly what Rogoff was thinking when he suggested Bernanke fan the inflation flames. (He didn’t respond to multiple interview requests.) I would have asked him: If 6 percent is good, is 10 percent better?

The idea was given short shrift in the blogosphere, especially by those whose economics is decidedly Austrian. The Mises Economic Blog calls Rogoff’s and Mankiw’s descent into madness the “Zimbabwe Solution.” Kevin Depew, executive editor of Minyanville, chides the economists for peddling snake oil, which is what inflation is.

And who says the Fed can orchestrate 6 percent inflation and not let it get out of hand? You know what would happen to those well-anchored inflation expectations: Ahoy, matey, it’s out to sea with you.

Trapped Logic

“Trying to manage a slight increase in the rate of inflation in a discretionary way is not practical,” says Marvin Goodfriend, professor of economics at Carnegie Mellon’s Tepper School of Business in Pittsburgh.

Or consider this: If the Great Moderation of the last 25 years has seen the purchasing power of the consumer dollar cut by more than half, imagine what 6 percent inflation would do.

The year-over-year change in the consumer price index hasn’t exceeded 6 percent on a consistent basis since the early 1980s. The idea that a central bank would want to throw away its hard-won credibility at a time when monetary policy is on overdrive is just plain silly.

What’s more, advocating higher inflation presumes central banks “can’t stimulate the economy at the zero bound without creating inflation,” Goodfriend says, referring to a presumed problem when the overnight rate is at zero.

That type of thinking is nothing more than an updated version of Keynesian liquidity trap argument, he says, referring to the idea that central banks become impotent when nominal rates approach zero. And it makes about as much sense.

Negative Nominal Rates

Mankiw didn’t specify his preferred inflation rate in the Bloomberg story. He was too busy to give me an interview, directing me instead to his New York Times column from last month where he proposed the idea of negative interest rates: not negative real rates, adjusted for inflation; negative nominal rates.

The idea is “to make holding money less attractive” so people will spend it. (Mankiw credits one of his graduate students with coming up with a way for the Fed to implement negative nominal rates.)

I like Greg Mankiw. The fact that he included my traditional Thanksgiving column in his macroeconomic textbook has nothing to do with it. I read his blog regularly because he makes good economic (read: non-ideological) sense.

This inflation idea is the exception to the rule.

Two Roads Diverged

Right now the investment community is divided over the direction of prices and the Fed’s ability to determining them: It’s either deflation or inflation, with no middle ground.

The deflation camp is looking at the burst credit bubble and the de-leveraging under way. Credit events are deflationary by nature: When lenders are hit with losses, they can’t make new loans.

The inflationists are looking at the Fed’s bloated balance sheet and the $877 billion of excess reserves banks are holding at the Fed. Pre-crisis they held some $1 billion to $2 billion of reserves over and above what they’re required to hold. The fear is that these reserves will morph into money -- and inflation -- quicker than the Fed can drain them from the banking system.

The last thing a central bank would want to add to this already potent brew is actual inflation of 6 percent.