Tuesday, September 29, 2009

Why Not Let Inflation Be?

With all the fiscal and monetary stimulus that has been poured into the economy, there is a lingering fear that inflation will rear its ugly head somewhere down the line. We've discussed how unanticipated inflation can take a bite out of both stock prices and free cash flow. But if inflation is allowed to creep higher, and is stabilized at a higher level, would that be a problem going forward for the broader economy? Assuming retirement benefit payments are linked to CPI, if our inflation target was 10% instead of 3%, would that be an issue? Common sense suggests nominal interest rates would adjust, and in the long-term this would have little effect on the country's real GDP (i.e. after adjusting for inflation). However, digging a little deeper we do find extra costs associated with a higher inflation rate, even when that rate is expected and anticipated!

First of all, a higher inflation rate (even when stable and fully anticipated) results in something called "shoe leather costs". These are the result of increased spending due to the fact that money loses value. Workers spend their paychecks as soon as they get them, since they could not buy as many goods next month with the same amount of money. Economist opinions of the relative quantity of these transaction costs range anywhere from 0% to 2% of GDP for a stable inflation rate of 10%.

One might think that a worker would get paid higher savings interest rates, therefore why would he spend his paycheck immediately? Unfortunately, tax consequences for savings distort incentives drastically. We pay taxes on our savings at nominal rates (i.e. the rate the bank posts). So if inflation is 10%, you would require at least that rate for your savings account. However, if your savings interest rate is 12%, after taxes your earnings would not be enough to offset the losses from inflation! As such, the savings rate has to increase dramatically, raising borrowing costs, which lowers investment and hurts long-term growth.

Finally, even with a stable inflation rate at a higher level, higher uncertainty persists. Will the inflation rate stay high, or will it come down? This uncertainty leads to lower investment, and a misallocation of resources, as portions of the economy will spend time and effort trying to profit from forecasting inflation rather than creating products and services that add value to society.

These are some of the main reasons why the Fed targets a low rate of inflation, and does everything in its power to keep it that way.

1 comment:

Andrew said...

"Assuming retirement benefit payments are linked to CPI"

to this point because of hedonics, geometric sequencing, and substitution CPI doesn't come close to reflecting the true inflation in conusmer prices. Also excess liquidity can also lead to asset price inflation which can be as much of a problem as consumer price inflation even though the almighty fed believes they are relativly unrelated.