Inflation, again

About six months ago I posted about the nonsense in worrying about inflation in the middle of a weak recovery. Since the topic keeps coming up as an argument against further monetary stimulus I want to point out that I was right then, and I still am. This is a dangerous thing to do in the economics profession: Irving Fisher, one of the greatest economists of all time, is best remembered for his statements about the “permanently high plateau” of stock prices months before the 1929 crash. But confidence abounds. Inflation won't take hold until capacity utilization is higher than average, driving the cost of production (and then prices) up[1]. The Fed can greatly influence inflation by raising (to lower inflation) or lowering (to increase inflation) interest rates.

It is pretty obvious that capacity utilization is still below average (think about the spare labor capacity). The people who have preached doom about inflation have been wrong now for four years, and have had a detrimental influence on government policy the whole time. In fact, since my original statement on the non-threat of inflation, inflation has dropped by over a percentage point.

Other measures of inflation tell much the same story.

Along with the fear of inflation, the Fed has been criticized for punishing savers and investors by keeping interest rates so low. Jim Demint recently admonished the Fed Chairman that he was costing Americans “about $400 billion a year on lost interest”. I didn’t bother finding out where the figure comes from because, though I understand the logic behind it, it is wrong.

All of this is related because during and after a financial crisis it is deflation that is the true threat. As Irving Fisher pointed out, the sever deflation that set in after the crash caused real debt burdens to increase. That is, deflation increased the value of outstanding debts faster than individuals, governments, and businesses could pay them off. The collective action of reducing spending to pay off debts merely increased the rate of deflation. 

 

The unshaded portions of the "1933" bars represent the amounts in 1929 $s. Notice that while national wealth decreased greatly internal debt actually rose.

The solution was easy, looser monetary policy to bring prices and inflation back to “normal” levels. By acting quickly and unprecedentedly this time around, the Fed stopped deflation and kept the downward spiral from kicking in. Since the average American household had debt of over 130% of disposable income, the Fed’s actions have saved Americans money by keeping their real debt burden from growing uncontrollably.


1. Capacity utilization varies around a rough (and quickly estimated) average of around 81-84%. Capacity utilization is currently around 78%, close, but it has been at that level for most of 2012. My argument isn't that inflation won't ever be a threat, but that it is not under current conditions. If capacity utilization increased enough to make inflation a threat it would mean the economy was recovering and the Fed could withdraw stimulus anyway. If inflation did start to rise to worrying levels it would be worth sacrificing short run growth for long run stability.