In the past, I’ve frequently argued that inflation is an almost meaningless and useless concept. I’m not even aware of any coherent definitions of the concept. Unfortunately, the Fed has decided to target PCE inflation, and thus we are forced to pay attention to the issue, and even forecast its future path.
Here are two problems with the inflation debate:
1. If the claim is that high inflation is an indicator of excessive aggregate demand, then why not focus on NGDP? If the claim is that high inflation is hurting living standards, then why not focus on real GDP? Inflation can be affected by both supply and demand shocks.
If people say inflation is too high or two low, there’s usually some sort of public policy implication to their claim. It’s not merely like saying the weather is too hot. (Oops, even that has public policy implications these days.)
In general, those who claim inflation is too high have a preference for a tighter monetary policy, and vice versa. But fast NGDP growth is a much better indicator of whether the economy is overheating.
In my view, the Fed’s recent decision to adopt “flexible average inflation targeting” is a tacit admission that NGDP is a better target. They are going to let undershoot or overshoot 2% on occasion if it allows for a more stable path for NGDP.
2. People foolishly divide up into two camps, hawks and doves. In 2019 the doves said, “Inflation is too low; we need more monetary stimulus.” The hawks said, “Don’t look at inflation; other indicators suggest we don’t need monetary stimulus.”
In 2021, the hawks say, “Inflation is too high, we need tighter money.” The doves say, “Don’t look at inflation, other indicators suggest that we don’t need tighter money.”
Of course it’s always true that inflation is an unreliable policy indicator. But I get tired of seeing people divide up into hawks and doves, and only use the “inflation numbers are misleading” argument when it favors their policy preference.
Hawks and doves are both wrong. We don’t need easy money or tight money; we need stable money. That’s why I didn’t believe the low inflation of 2019 was a problem and it’s also why I don’t think the high inflation of 2021 is a problem. Inflation is not a reliable policy indicator.
You should immediately distrust any pundit who only discounts the importance of inflation when it’s below 2% (i.e. hawks) and you should also discount any pundit who only discounts the importance of inflation when it’s above 2% (i.e. doves.)
Over the past 100 years, bad outcomes have occurred when we adopted dovish policies, and also when we adopted hawkish policies. Good outcomes have occurred when we adopted stable monetary policies.
READER COMMENTS
Andrew_FL
Jun 15 2021 at 6:01pm
Do you think this argument applies in cases of hyperinflation?
Scott Sumner
Jun 15 2021 at 8:14pm
With hyperinflation the various price indices and NGDP give almost identical readings, so the argument that NGDP is better loses much of its force.
Thomas Lee Hutcheson
Jun 15 2021 at 6:49pm
I agree if by “stable” we mean a predictable rate of inflation that balances making it easier for relative prices to adjust to shocks given that some are sticky downward without making it more difficult to predict relative prices in the future. As far as I know, 2% PCE looks like about it.
Market Fiscalist
Jun 15 2021 at 9:47pm
Slightly off topic (though Scott does elaborate on his views on inflation) – I really enjoyed Scott’s discussion with Bob Murphy : https://www.bobmurphyshow.com/episodes/ep-204-scott-sumner-argues-the-bernanke-fed-was-too-tight/
Michael Sandifer
Jun 15 2021 at 10:01pm
You often judge the Fed from within the parameters of its targeting regime, and hence when core PCE inflation is only an average of ~1.6% over the decade following the Great Recession, I think it’s safe to say money was tight over that period, given the Fed’s explicit 2% target. Most economists argue that it stopped mattering, perhaps halfway through that decade, as wages adjust, but I don’t think the adjustment occured that quickly. The nominal neutral rate wasn’t much above zero, even by 2017 when the economy finally really began to heat up. I think ultimately, the neutral rate was lower during the worst of the recession than realized, and that’s part of the reason most economists misjudged NAIRU and potential RGDP.
Yes, inflation is an artificial construct, and yes it should not be the sole focus of a monetary policy targeting regime, but I think it’s easily definable, at least in the abstract. And in terms of the gritty details of actual numerical measurement, I don’t see much evidence that economists do a bad job, though, as Tyler Cowen points out, precise comparisons across long time frames are probably not possible.
Don Geddis
Jun 15 2021 at 10:40pm
With a bold claim like that … don’t you think you owe it to the rest of us to actually provide this “easy” definition?
Here, do a concrete example for me: In 2002, a gallon of milk cost about $2.76; in 2012, a gallon of milk cost about $3.49. In 2002, an iPhone could not be purchased even if you offered $1 billion; in 2012, an iPhone 5 was $649 (without a contract).
In a simplified economy with only those two products and four mentioned prices, what is the implied annual inflation rate in the decade between 2002 and 2012 given your “easy” definition?
robc
Jun 15 2021 at 10:48pm
Easy definition:
Change in M2 over time (or M3 or whatever measure of money you want to use). What do prices have to do with inflation?
Brian
Jun 15 2021 at 11:20pm
Well he did say “precise comparisons across long time frames are probably not possible” so rather than measure inflation from 2002 to 2012, just measure it from one year to the next. Then if you want a 10 year inflation rate, sum the ten rates (Actually multiply each rate plus one). If a certain product didn’t exist in 2002 but did exist in 2003 it doesn’t matter much because not much money was spent on that entirely new product so just pick a product that did exist both years.
Michael Sandifer
Jun 16 2021 at 1:18am
Inflation is what occurs absent sticky wages. If all prices, including wages, adjusted in unison, inflation would have no real effects and no one would care about it. So, perhaps counter-intuitively, inflation is the more “natural” result of changes in expected money supply growth versus demand, as opposed to what is normally the much larger real result, which is the change in real GDP.
This is how we know that sustained increases in inflation can only occur to the degree wages are flexible. If nominal wages don’t begin to rise with inflation, consumers will simply not have the money to sustain the demand to push prices higher.
Billy Kaubashine
Jun 16 2021 at 10:17am
What about lenders and borrowers?
Even if all wages and prices adjusted in unison, inflation would have very real effect on the value of loan balances.
Michael Sandifer
Jun 16 2021 at 3:38pm
Billy, yes many commit the error of making such an assumption, but you’re stuck thinking in the world of sticky wages. If you think about it, probably see your error.
Scott Sumner
Jun 16 2021 at 9:25am
Yes, measurement problems are smaller when you look at shorter periods of time, such as 12 months. But it is also true that the volatility of inflation tends to be pretty small from one year to the next.
Lizard Man
Jun 16 2021 at 2:56am
Is it accurate to say that inflation is high when there is very little excess productive capacity and low when there is a lot of excess capacity? What you want is a monetary policy that doesn’t slow down changes and adjustments in the economy. Medium term inflation seems like a good proxy measure for whether Fed policy is too loose or too tight.
Somewhat related question, if a central bank has an NGDP target of 5%, and the economy grows by 7% in real terms, will that be any different than an economy with a 9% NGDP growth target 7% real growth? My instinct is to say that the deflationary environment and inflationary environment have different kinds of financial risks and systems, as well as different consumer behavior.
Scott Sumner
Jun 16 2021 at 9:22am
You asked:
“Is it accurate to say that inflation is high when there is very little excess productive capacity and low when there is a lot of excess capacity? ”
No it isn’t, as we learned in the 1970s. I’ll do a post on that soon.
The financial system can do fine with either 5% or 9% NGDP growth, but 5% produces a more efficient tax system. Deflation is not a problem if NGDP growth is 5%.
Lizard Man
Jun 17 2021 at 10:28pm
I look forward to the post on the 1970’s. But still, I thought that what happened was that the price of oil increased, making a bunch of previous modes of production uneconomic. So that would be a situation in which there were a lot of people and factories that were idle, but that would be a kind of mirage. Were we to start running out of coal, would it count as a reduction in capacity of coal fired electricity generation or as a huge amount of idle capacity?
Scott Sumner
Jun 19 2021 at 1:02am
No, the high inflation of the 1970s was not caused by oil—indeed even NGDP growth was in double digits.
Michael Rulle
Jun 16 2021 at 10:10am
I have wanted to have you weigh in on this topic——and am glad you have. As mentioned before, I too thought Powell was, or might be, a secret NGDP targeting guy—-at least in part. Had not explicitly thought his range on inflation was the hint—-but it likely is.
One thing is obvious——if the standard WSJ writers and interviewees are the mainstream——you could not be more outside the mainstream if you tried. They are obsessed with the same things they have been since I could read. This is bad news. You have had influence—-but not with the standard crowd—-you are the continuation of Friedman—-whose name I have not seen in WSJ in years.
If I learned one thing from MF it was the importance of stable, transparent monetary policies. My major critique of Powell is he is not loud enough——although I admit that might be a necessary tactic—-as he too is outside mainstream.
Powell is not an economist. That is interesting. I wonder if he will be re-elected—-or even wants to be. If not, the next guy will be a “mainstreamer”
Maybe your book will be persuasive. Maybe you are targeting its release to have an impact on the next Fed Chair. But that assumes you are writing it for a general audience (like Road to Serfdom—-as an example)—-as opposed to other economists.
I hope at least the main points target a general audience. That is hard to do.
derek
Jun 17 2021 at 9:05am
I would say that WSJ is catering to its audience: stockbrokers, traders, business people, etc. While from a policy perspective we (should) care about NGDP, business people would be making their decisions based on things like interest rates I would think.
Michael Rulle
Jun 16 2021 at 10:36am
RE: Friedman——-he said, I believe, that unexpected changes in inflation were the problem not inflation per se. Your comment on “5% versus 9%” NGDP is the same concept. I had not thought of tax issues. You have answered a question I have wondered about. Just more evidence our system of taxes is designed for favors.
Philo
Jun 16 2021 at 11:25am
“[I]inflation is an almost meaningless and useless concept”? Well, though I am not offering a definition, I judge that something important was happening in the U.S. in the 1970s—and still more (“hyper”) in Weimar Germany, Zimbabwe, Venezuela, etc.—that calls for a description using this very concept.
Philo
Jun 16 2021 at 11:29am
I do agree that monetary policy had better be carried out without reference to inflation; I disagree that the concept is altogether useless.
Scott Sumner
Jun 16 2021 at 1:20pm
The problem in the 1970s was double digit NGDP growth.
Justin
Jun 23 2021 at 9:58am
Double digit NGDP growth is only a problem if most of that is inflation. China has often had double digit annual NGDP growth without consequence.
Alan Goldhammer
Jun 16 2021 at 1:31pm
Too often economists lose sight of the trees in the forest. Here is how trusty Google defines it, “a general increase in prices and fall in the purchasing value of money.” To the average person this is not to quote Scott,
but rather one that the ordinary person with little or no economics background can fully understand.
Scott Sumner
Jun 17 2021 at 1:26am
You said: “but rather one that the ordinary person with little or no economics background can fully understand.”
Having taught economics for 35 years, I can assure you that very few college students understand the concept of inflation.
Ask the average person what the term “value of money” means.
Alan Goldhammer
Jun 17 2021 at 7:50am
Doesn’t this disturb you? I never took an econ class in college but it’s pretty clear to me when inflation kicks in. I have an Excel spreadsheet that documents all the cash flows for the two of us (kids are grown and out of the house). I can tell you from month to month whether costs have increased or decreased. I don’t understand why this is such a difficult concept at the personal level.
Obviously at the macroeconomic level things become more complex but that was not my main point. I think you are arguing about this type of complexity, which I agree the ordinary person cannot understand. Direct pocketbook impacts they can.
Scott Sumner
Jun 17 2021 at 1:31pm
You said:
“I have an Excel spreadsheet that documents all the cash flows for the two of us (kids are grown and out of the house). I can tell you from month to month whether costs have increased or decreased. I don’t understand why this is such a difficult concept at the personal level.”
Yes, month to month changes in cash flow are easy to measure, but that’s not what inflation is. That’s closer to NGDP.
Peter McCluskey
Jun 16 2021 at 1:32pm
How about creating a new measurable concept for the Fed to target that’s focused on the harm from sticky wages?
A very crude start would be the fraction of the labor force that hasn’t had a nominal wage increase in the past 2 years.
Scott Sumner
Jun 17 2021 at 1:27am
You said:
“A very crude start would be the fraction of the labor force that hasn’t had a nominal wage increase in the past 2 years.”
That’s not what economists mean by sticky wages. In the 1970s, wages were rising at 10%/year and yet were just as sticky as today.
Grand Rapids Mike
Jun 17 2021 at 9:13am
Whatever the measure of inflation, when you have too much of it one’s interest on real savings is negative, which for many people is a negative. It seem it distorts investment decisions, making risky investments more likely for those not understanding of higher risk assets. So inflation increases distortions, creating the boom and bust cycles, and thus more job opportunities or talking points for economist.
Dale Doback
Jun 17 2021 at 11:33am
If inflation is a useless concept, then doesn’t it follow that real variables (like GDP) are also useless?
Scott Sumner
Jun 17 2021 at 1:28pm
Yes, I’d use other variables like NGDP for macro policy. RGDP is fun to talk about as an indicator of rising living standards, but it’s utterly unscientific.
Hellestal
Jun 17 2021 at 3:30pm
“Are you a hawk or a dove?”
“Neither. I’m an eagle. I fly far above the petty distinction between hawks and doves.”
cody mc
Jun 17 2021 at 7:41pm
What do you think of the Austrian/ a priori definition of inflation? Is it just tautology and has nothing to do with the real world or does it actually provide insight? If it were true it would make inflation something of a civil rights issue regarding the extent to which debasement is allowed
Scott Sumner
Jun 19 2021 at 1:04am
It’s a free country and people can define terms as they like. I use terms according to the standard definition, not my own private definition. I don’t find alternative definitions to be very useful, as they just cause confusion..
David S
Jun 18 2021 at 12:17pm
Scott’s emphasis on stable monetary policy is probably why he approaches crypto with such caution—it’s the ultimate unstable money.
I never knew what NGDP was until I started reading economics blogs about 10 years ago. My Econ 101 class back in the 90’s didn’t dwell too much on inflation as I recall. NGDP as a concept has helped me understand the 50’s and 60’s better. Annual wage increases on the order of 5% seemed like a normal thing, but it contributed to volatility in the 70’s. In my working lifetime I’ve associated wage increases with performance improvements, but respect that there’s a non-scalable limit to my value.
Low wage workers are probably better served by a stable NGDP growth rate of around 4%-6% (like Scott has suggested). They can more easily keep track of how much they’re getting screwed on a year to year basis.
Michael Sandifer
Jun 18 2021 at 9:25pm
I took some econ classes as an undergrad, and I came out of it with no real understanding of inflation, real GDP growth, monetary policy, etc. I’ve learned most of the little I think I know from market monetarists like Scott, and in more recent years, by looking at lots of data.
Scott Sumner
Jun 19 2021 at 1:06am
You said:
“Scott’s emphasis on stable monetary policy is probably why he approaches crypto with such caution—it’s the ultimate unstable money.”
It’s more a question of crypto not filling the role of medium of account. My blog doesn’t focus on “money” broadly defined, it focuses on the medium of account. I also ignore the M2 money supply.
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