Why is inflation bad?
With the 12-month rate of CPI inflation now at 6.2%, inflation is once again in the news. Should we worry about inflation? If so, why?
I have what might seem like contradictory views on inflation. On the one hand, I’m an inflation hawk who came of age in the 1970s and I view the high inflation of that decade as a major policy mistake. On the other hand, I’ve argued that inflation doesn’t really matter, that the so-called “welfare costs of inflation” are better measured by looking at NGDP growth. And a model produced by David Beckworth suggests that NGDP is back on track:
Of course, the 1970s didn’t just have high inflation, that decade also saw wildly excessive NGDP growth (11%/year from 1971-81), so there were good reasons for inflation hawks like me to worry about high inflation even if in some sense inflation doesn’t matter. The metric we prefer was just as excessive.
If you ask the average person why they worry about inflation you quickly realize that their actual concern isn’t inflation; it’s something more like falling real GDP. Thus they might fear that higher prices will cause a fall in their living standards. But higher prices are a zero sum game; they do not directly reduce the living standards of Americans. At this point some will shift the argument to “distributional effects”, and claim that some people are getting rich while the poor are being hurt by inflation. As Matt Yglesias pointed out today, however, the poor are seeing their incomes rise faster than any other group:
Real GDP growth has been lower than normal over the past 7 quarters, but growth is far better than in 2008-10, and that’s because the Fed switched to a monetary policy closer to what market monetarists like myself recommended back in 2008-09. At the time, we were told that a commitment to return prices or output to the previous trend line would make no difference at the zero lower bound. In fact, quickly bringing NGDP back to trend has resulted in a much better performance for RGDP, and hence living standards, relative to what we saw in 2008-10.
So why is inflation bad? After all, if one person pays more for a good, another receives more. And there’s really no evidence that the distributional effects favor the rich. The stock and bond markets did horribly during the high inflation 1970s. So why is inflation bad?
The textbooks say that one problem is menu costs, the cost of changing prices in menus, but those are pretty trivial. The main cost of inflation is that raises nominal interest rates. One cost of higher nominal rates is that people go to the ATM machine more often, but again that cost is pretty trivial. The main cost of higher nominal interest rates is that they distort the tax system. Higher inflation raises the nominal return on investments, which causes the real tax rates on investment to be higher than otherwise. I used to teach my students that if the nominal interest rate were 12% and the inflation rate was 10%, then the real rate of return would be 2%. If you then added a 50% tax on investment income, the real rate of return falls to minus 4% ((0.5*12%) – 10%). That’s a real tax rate of 300%. Thus inflation discourages saving and investment.
But note that the mechanism by which inflation discourages saving and investment is by raising nominal interest rates. In the previous example, in an economy without inflation the after-tax real rate of return would be 1% (50% of 2%), not minus 4%. Oddly, the recent bout of inflation has not raised nominal interest rates. The nominal rate on 5-year Treasury bounds is about 1.2%, while the real return on 5-year TIPS is negative 1.9%. Read that again, you earn negative 1.9% per year by investing in Treasury notes. And the TIPS inflation adjustment is also taxable.
Thus while the stock market did horribly from 1966-82, stocks have done very well in recent years. This time around, inflation has not resulted in high nominal returns on risk-free investments, and thus has not distorted our tax system to anywhere near the extent it did in the 1970s and early 1980s, when yields on Treasury bonds rose to nearly 15%.
So how should we think about the “inflation problem” that most consumers worry about? It’s not really an inflation problem; it’s a real GDP problem caused by supply chain disruptions. So yes, some people are suffering, but it’s not useful to think that “inflation” is the source of their problems; rather it’s a lack of real GDP growth. If you thought inflation was the source of the problem, then you’d advocate that we switch back to the failed policies of 2008-10. But the solution is not tighter money, it’s supply-side reforms.
This is not to say that we don’t have any inflation problem at all, i.e. an excessive rate of NGDP growth. While NGDP is roughly back on track, it now looks to me like we are going to overshoot what David Beckworth and I view as “neutral”. The TIPS spreads are too high. So I favor the Fed tapering, and indeed would like them taper even faster.
PS. After linking to Beckworth’s graph, Matt Yglesias had this to say:
I’m increasingly worried about the fact that I find myself agreeing with Yglesias more and more often. Hopefully, this is because he’s moving in my direction. I’d hate to think that I’m moving in his direction. 🙂