How to think about inflation and deflation

The March consumer inflation numbers showed prices rising faster than expected and up from last month. In the 12 months through March, consumer prices increased 1.5% versus 1.1% in February. The core CPI, which strips out the volatile energy and food bits, rose 1.7% versus 1.6% in February.

Analysis from IHS Global Insight: “Overall, the consumer inflation story is relatively bland. However, the direction of food prices is somewhat worrisome. Average consumers will have no cause to consider inflation rampant, but living standards will suffer as a larger percentage of household budgets are spent on grocery store bills, leaving less for discretionary spending.”

Overall, inflation really is benign, especially given the Fed’s avowed 2% target. In fact, some economists have been worried that inflation has been too low, maybe risking outright deflation. As AEI economist John Makin wrote in a recent report, “Inflation is falling in the United States, Europe, and China, suggesting a real threat of impending deflation that could cripple the global economy.” To get some more insight on inflation, I asked a few questions of Makin, and economist/blogger Scott Sumner of Bentley University:

PETHOKOUKIS: There seems to be concern out that that inflation is running too low. But isn’t low inflation a good thing? Isn’t that the great Volcker victory of the 1980s? Along those lines, are some kinds of inflation and deflation good or bad?

MAKIN: Low and steady inflation is a very good thing. Volcker withstood immense heat for the pain tied to bringing inflation down from 10% to about 3%. But the benefits were substantial– avoiding destabilizing higher inflation and setting the stage for a huge equity bull market after 1982′ when he relaxed tightening. The drop in inflation cut tax receipts so much that the deficit rose faster than expected – a constructive form of fiscal stimulus.

Relative price changes, brought about by rapid price increases or decreases in some goods/ services are good and self-correcting. But when most prices are rising or falling consistently, movements can become self- reinforcing and damaging to the economy. Higher inflation is usually more volatile. That boosts uncertainty in a way that has been shown empirically to harm growth. Disinflation is fine, until and if it turns into deflation which almost always is associated with lower growth, weaker investment and higher unemployment — as in the Great Depression and In Japan after 1997.

SUMNER: Never reason from a price change. Whether inflation is good or bad depends on whether it is supply or demand-side inflation, and whether aggregate demand is currently excessive.

In short: (a) Supply side inflation is bad, but it isn’t really the inflation that hurts, it’s the fall in real GDP from the adverse supply shock. Thus holding nominal GDP constant, higher prices mean less real output, which is bad; (b) Demand side inflation can boost both prices and output, which can be good. But only if the economy is currently depressed from an adverse demand shock. In my view that’s been true of the US economy since late 2008, although it becomes a bit less true as unemployment falls back closer to its natural rate (which is hard to estimate.)

In my view it makes more sense to talk about boosting nominal spending than boosting inflation, because that language better conveys what the central bank is actually trying to do.

In terms of the trend rate of inflation, Volcker was surely wise to bring it down from double digits. But all he did is bring it down to 4% in late 1982, where it remained throughout the rest of the 1980s. Today it’s about 1.5%, so a bit higher inflation would be needed if the Fed is serious about its 2% long run target. There are costs and benefits from a lower or higher trend rate, and no one (including me) knows what trend rate of inflation is optimal. I suspect it’s close to 2%, but the exact rate depends on other aspects of policy. Under current (inept) Fed policy it’s probably close to 3%, as that makes the zero bound on interest rates less likely.

PETHOKOUKIS: It looks like the ECB might start a quantitative-easing, or bond buying program. Would that help the EZ economy?

MAKIN: The usual criticism of incipient QE or other anti-deflation measures is that they won’t work. Japan suffered under this delusion for 15 years until late 2012. Successful reflation requires a higher inflation target from the central bank that it is committed to meeting with substantial money printing until prices start to rise– the exchange rate starts to fall. A central bank has to credibly promise higher inflation to beat deflation. Many cannot bring themselves to do it, as is I fear, the case with the ECB.

SUMNER: QE would help in the eurozone, but I’d prefer they set a nominal GDP target, or if they continue to inflation target they should do level targeting of prices, which means promising to catch-up for any shortfalls from their inflation target (assumed to be about 1.9%).

Follow James Pethokoukis on Twitter at @JimPethokoukis, and AEIdeas at @AEIdeas.