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EVAN HOROWITZ | QUICK STUDY

Why a little inflation isn’t a bad thing

Associated Press/LM Otero/File

By Globe Staff 

It doesn’t take much to stoke fears of inflation. Last week, after news that consumer prices had risen a higher-than-expected 0.5 percent in January from the previous month, economic analysts started raising alarms, and a short-lived shock wave reached all the way to Wall Street.

Quickly, though, the stock market shrugged off the news, and maybe the rest of us should, too. In fact, far from being a worrying sign of impending economic doom, a little extra inflation might be just what our economy needs. It would help us prepare for the next recession while making it easier for households — and the federal government — to manage their rising debts.

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Before you balk, no one is talking about returning to the bad old days of the late 1970s, when prices sometimes rose more than 10 percent a year. Currently, the Federal Reserve’s preferred inflation measure is below 2 percent, and the only question is whether we’d be better off if it were closer to 3 percent — or, at the extreme, maybe 4 percent.

There is already a strong consensus that some inflation is good, because it serves as an incentive to spend. If you know prices are going up — and by extension that those dollar bills in your pocket are going to get less valuable — it would be foolish to hold on to them for too long. By contrast, if prices are going down, you could always get a better deal by waiting until next month.

In recent decades, the Federal Reserve and other central banks around the world have tended to embrace an inflation target of about 2 percent. But that number was always a bit arbitrary, and recent changes in the global economy have many economists wondering if it’s dangerously low.

Here’s the problem: One of the chief responsibilities of the Federal Reserve is to fight against recessions, and low inflation makes that harder to do.

The Fed’s favorite weapon is its ability to cut interest rates, and total cuts of 5 to 6 percentage points have been the norm in recent recessions. But there’s a first-grade math problem you can’t avoid. It’s possible to cut rates 5 percentage points only if you start with rates that are over 5 percent. Otherwise, you’ll hit zero and get stuck.

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Right now, the Fed’s key interest rate — the federal funds rate — is around 1.5 percent, and the Federal Reserve doesn’t expect it to get much higher — not even over what it calls the “longer run.” Which makes the United States more vulnerable to recession than we’ve been in decades.

There’s a solution, though: higher inflation.

Because while interest rates get all the attention, what really matters for Fed policy is the combination of interest rates and inflation rates. They work together, either to provide stimulus to an ailing economy or to constrain an overheating one.

And while the details can get knotty, the short version is that higher inflation allows for more stimulus, even at very low interest rates. So if the United States does hit a recession, and the Fed has already cut interest rates to zero, those zero rates would be significantly more potent if inflation were running close to 4 percent, rather than 2 percent.

This alone may suffice as a reason to embrace higher inflation, but there are other benefits.

A hit of inflation would be good for debtors, a big constituency in this country.

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Imagine you’re a homeowner with a monthly mortgage payment of $2,000. As inflation goes up, the real value of your house doesn’t necessarily change, but that $2,000 payment gets less and less costly (in the sense that it would buy fewer other things, clothes or cars or day care, since the prices of those things are rising.)

The net result is that you’re effectively paying less each month for the same benefit. And while it’s true that your paycheck would also get less valuable, note the imbalance. You can renegotiate your salary with your employer — arguing that inflation is driving up prices — but your bank has no such right to renegotiate a fixed-rate mortgage. They just eat the loss.

Indebted governments would see similar benefits, including state pension systems, whose long-term burden would be greatly eased, not to mention the US Treasury, which would find it easier to repay old bonds.

Higher inflation could also help businesses manage their labor costs, particularly when it comes to dealing with underperforming workers. Right now, with inflation low, the only way to pay a worker less is to actually lower the salary, which is terrible for morale. But in a world with higher inflation, there’s a better option. Employers can let inflation do the cutting for them. Were inflation running at 3 percent, businesses could offer less-productive employees a 2 percent raise — and it would really be a cut, even though it wouldn’t feel that way.

All these benefits come, it is true, with some costs. What’s good for debtors is necessarily bad for creditors, including banks, and any boon to state pension systems is bad news for pensioners, who end up with less-valuable benefits.

But it’s important to be consistent here. Yes, higher inflation would create winners and losers. But so does low inflation, and the US economy has been enduring those costs for the better part of a decade.

Without higher inflation, we may end up paying a much higher price in the form of a recession we can’t beat back.


Evan Horowitz digs through data to find information that illuminates the policy issues facing Massachusetts and the United States He can be reached at evan.horowitz@globe.com
Follow him on Twitter @GlobeHorowitz.