An interesting little footnote to one of the big questions facing central banks around the world. What
The interesting footnote is that it turns out that Janet Yellen was the person with the right answer, at least in the US context:
“To my mind the most important argument for some low inflation rate is the ‘greasing-the-wheels argument,'” Ms. Yellen said in a closed-door meeting of Fed policy makers in July 1996.
When businesses run into rough times, they may be inclined to cut workers’ pay. But in practice, that doesn’t happen much. Even in a severe downturn, businesses are more likely to cut hours, conduct layoffs or keep positions vacant than cut pay. That’s one reason recessions tend to lead to higher unemployment instead of lower wages.
Inflation helps deal with this problem. When there is a bit of inflation, employers can hold workers’ pay steady during a downturn yet have it decline in inflation-adjusted terms. Inflation creates an adjustment mechanism: An assembly line worker may keep making exactly $20 an hour through a downturn, but in inflation-adjusted terms that pay falls by 2 percent a year, which could make the factory less likely to resort to layoffs.
This isn't a new argument, of course it isn't. It flows entirely naturally from Keynes' own point that nominal wages are sticky downwards. People really, but really, hate to have the number of $ they take home in their pay packets go down. But they're a lot more accepting of a fall in real wages if their nominal wages stay static (and even more so if they rise) while inflation reduces the real value of those wages. This is one of the very reasons that Keynes insisted that an economy could be trapped in a suboptimal equilibrium: sure, the correct solution is for real wages to fall but people resist that strongly therefore we get that higher unemployment, not the fall in real wages required.
The question being debated today is whether that 2% is too low a target, doesn't provide enough grease in the bad times. My own opinion (and as far as macroeconomics is concerned I'm never going to offer anything stronger than an opinion, shown I don't know enough about it too often to do that again) is that the 4% some are talking about is too high. In reality that would mean inflation gyrating between 2 and 6%. And at the upper end of that range the effects are a lot more damaging than at the lower. At and around 2% prices double every 35 years. Except for some very long term decisions (pensions and houses most obviously and we'll get those horribly wrong if we don't include expected inflation) that means we can generally ignore inflation in most of our economic and financial calculations. At 6% prices double every 11.5 years. Meaning that a much larger subset of our economic decisions have to take expected inflation into account. That change would be very expensive in terms of the effort we would all have to pay to expected future inflation. Plus, of course, nominal interest rates do matter and a world where 6% inflation could be routinely expected would have very much higher nominal interest rates than today.
Finally, there's an interesting little bit of serendipity in the last two picks for Fed Chair. Yellen was right about 2% inflation targeting and she became chair and now, when she is, the discussion about that 2% target is coming up again. But of course we could say that she became chair in part because she was right about the 2%. With Bernanke, her predecessor, I find it more amusing. He was, before appointment, a great propounder of The Great Moderation theory (modern economies don't have great booms and busts anymore. Well, yes, nice idea while it lasted) and we might say that he became chair because as late as 2006 that was the general consensus. But he made his academic bones studying the response of the Fed itself to the Great Depression. And urged on by Milton Friedman he was certain that the Fed's actions were what caused the Depression (not the crash before it, but turned what would have been a nasty recession into that Depression). Which was really quite useful in 2008 when he was able to make sure it didn't happen again: unlike over here in Europe where the ECB seems never to have received Uncle Milt's memo. Serendipity? Forward planning? The former I think: but we should all be rather grateful for it all the same.
