Hygro
soundcloud.com/hygro/
Inflation is bad, right?
Right?
It makes our savings dwindle, and risks outstripping wages making us poorer. It makes banks less interested in lending without increasing interest rates. It makes it then harder for businesses to achieve credit, which of course means that growth, expansion, hiring new workers, etc becomes more difficult hurting the economy on both the supply side and the demand side. It makes investments in general more risky as they might not beat inflation, and you can't count on breaking even in the case the venture goes nowhere and sits on its depreciating capital.
I'm currently writing a paper arguing the opposite of this thread, thanks to the concept of "anchored expectations", but in the process, will try to make the case for why we might want a big spike in inflation to get us out of this weak economy, and reduce the risk that this becomes "the new normal" (really slow economic growth).
We will make the case based on some intuition-friendly logic.
Part 1
There's a concept in monetary policy known as the "Zero Lower Bound" or ZLB which means "interest rates can't be dropped below zero." Though there are small exceptions, but people will choose to hold cash rather than put their money in negative-return accounts.
When the economy hits the ZLB, the Fed cannot do any more stimulus by cutting interest rates. Cutting interest rates is the smoothest, choicest first-step action to fix a recession. (This is why the Fed has been using other ways of stimulating the economy like Quantitative easing). Another name for the ZLB is a "liquidity trap" (this will be important) which you likely have heard of.
The ZLB is slightly adjusted by expected inflation (also important), specifically, the more we expect inflation, the lower the bottom interest rate can be. This is because holding cash in the face of inflation is losing money, so if there's a sub-zero interest rate above inflation, it's effectively a positive interest rate.
We will assume that in general, expected inflation matches real inflation since they often are.
So to conclude part one, the Fed can effectively lower interest rates by increasing inflation. The more inflation, the lower the ZLB is, and the more effective the bottomed out interest rate has on stimulating the economy.
Still with me? If not, ask for a clarification.
Part 2
As inflation moves, the Fed wants to adjust interest rates. If inflation is low, this means that interest rates should be low. The reason1 is simple: if interest rates were well above inflation, everyone would park their excess money in treasury bills and neither consume not invest in the private sector, hurting growth. Sure, you're loaning to the government but they can deficit spend so it's not like you're increasing the governments' ability to pay for things, (at least in the short run! And this discussion is about the short run, i.e. a few years caps). When inflation goes up, the reverse is true. To stop inflation hurting the economy, the Fed raises interest rates pulling money out of circulation, keeping prices from rising.
1. One reason, anyway. There are others.
Generally, there's a consensus that lower inflation and lower interest rates are good for the economy. Stable prices, easy investment, etc. There's such a thing as too low, but it's a much smaller gap than the infinitely too big
But if inflation drops too much, the Fed cannot drop interest rates below the ZLB! Now more people want to park their money in T-Bills. ~0% is better than whatever negative inflation is going on. So as the gap between inflation and the interest rate drops, more and more businesses and individuals will park their money there. Worse2 yet, as this point is likely deflation, there is extra incentive to hold on to your now appreciating cash or stocks of T-Bills, reducing further spending/consumption and investing in private enterprise, which can cause a deflationary spiral. A bad positive feedback loop.
2. We'll assume economic recession is bad. There are counter arguments.
So here we see another angle of the problem. The ZLB means the Fed can't incentivize investment over cash holdings, and worse yet, can cause consumption to slow down creating a vicious cycle.
Part 3
If we combine parts 1 and 2, we have side of the big polygonal conundrum. If a lower inflation rate raises the ZLB, and deflation can push the ZLB above 0% nominal (like, the technical number) interest rates, and if this can create a deflationary feedback loop, the zero lower bound can continue to get worse and worse, further exacerbating the problem. Now we have not one but two variables causing the feedback loop! It's not infinite, of course, because at some point someone's gotta spend their money on something. Necessities like food, worn out clothes, etc, but also someone's going to want a new home, a new TV, a new modem, and waiting for prices to drop isn't going to be worth it. But that point will be after our economy shrinks and shrinks to the point of massive unemployment well above today's and other things that hurt people a lot.
Still with me?
Part 4
The above double feedback loop in part explains the nature that a drop in aggregate demand above the ZLB means a drop the overall economy, but the same drop in demand below the ZLB means a much bigger drop in the economy.
Part 5
There are a few reasons we, fortunately, never hit the deflationary death spiral in the latest economic crisis. The first is "anchored expectations." The Fed has been so good at controlling inflation during the Volcker-and-especially-Greenspan era that people have come to believe that inflation is more or less a given at its current rate of ~2%. The second is that despite the deflationary pressures which could change peoples' minds, fears of inflation by due to the stimulus and QE and effectively interest free bank loans put inflationary pressure on the economy. These opposing factors, combined with the first element, served to keep inflation steady.
So while the worst effects of the ZLB were largely mitigated, we are still hampered and harmed by it.
Finale (drumroll)
Because today were are below "long run equilibrium" which means we are not meeting our annual historical GDP growth rate of about ~2.5%. Interest rates are at zero and the Fed keeps doing alternative measures to boost aggregate demand in the economy like special loans to banks and buying up risky assets above their market/firesale prices. Meanwhile political gridlock meets economically misinformed Congresspeople makes fiscal stimulus an unlikely reality.
The Fed still has many tools under its belt but a simple, immediately effective, no-money-spent stimulus would be to simply announce it will pursue, say, a rate of 4% inflation per year. Because the Fed is totally capable of this, expected inflation would change very rapidly and would result in more people turning from cash to investment and consumption. In turn this would boost employment which would boost consumption further. In other words, it would speed the recovery and rate of economic growth, something we could use, since this is one of the slowest and most precarious recoveries America has ever seen.
We don't want to be like Japan, whose recovery was so slow, their long run equilibrium growth dropped, more or less permanently.
Right?
It makes our savings dwindle, and risks outstripping wages making us poorer. It makes banks less interested in lending without increasing interest rates. It makes it then harder for businesses to achieve credit, which of course means that growth, expansion, hiring new workers, etc becomes more difficult hurting the economy on both the supply side and the demand side. It makes investments in general more risky as they might not beat inflation, and you can't count on breaking even in the case the venture goes nowhere and sits on its depreciating capital.
I'm currently writing a paper arguing the opposite of this thread, thanks to the concept of "anchored expectations", but in the process, will try to make the case for why we might want a big spike in inflation to get us out of this weak economy, and reduce the risk that this becomes "the new normal" (really slow economic growth).
We will make the case based on some intuition-friendly logic.
Part 1
There's a concept in monetary policy known as the "Zero Lower Bound" or ZLB which means "interest rates can't be dropped below zero." Though there are small exceptions, but people will choose to hold cash rather than put their money in negative-return accounts.
When the economy hits the ZLB, the Fed cannot do any more stimulus by cutting interest rates. Cutting interest rates is the smoothest, choicest first-step action to fix a recession. (This is why the Fed has been using other ways of stimulating the economy like Quantitative easing). Another name for the ZLB is a "liquidity trap" (this will be important) which you likely have heard of.
The ZLB is slightly adjusted by expected inflation (also important), specifically, the more we expect inflation, the lower the bottom interest rate can be. This is because holding cash in the face of inflation is losing money, so if there's a sub-zero interest rate above inflation, it's effectively a positive interest rate.
We will assume that in general, expected inflation matches real inflation since they often are.
So to conclude part one, the Fed can effectively lower interest rates by increasing inflation. The more inflation, the lower the ZLB is, and the more effective the bottomed out interest rate has on stimulating the economy.
Still with me? If not, ask for a clarification.
Part 2
As inflation moves, the Fed wants to adjust interest rates. If inflation is low, this means that interest rates should be low. The reason1 is simple: if interest rates were well above inflation, everyone would park their excess money in treasury bills and neither consume not invest in the private sector, hurting growth. Sure, you're loaning to the government but they can deficit spend so it's not like you're increasing the governments' ability to pay for things, (at least in the short run! And this discussion is about the short run, i.e. a few years caps). When inflation goes up, the reverse is true. To stop inflation hurting the economy, the Fed raises interest rates pulling money out of circulation, keeping prices from rising.
1. One reason, anyway. There are others.
Generally, there's a consensus that lower inflation and lower interest rates are good for the economy. Stable prices, easy investment, etc. There's such a thing as too low, but it's a much smaller gap than the infinitely too big
But if inflation drops too much, the Fed cannot drop interest rates below the ZLB! Now more people want to park their money in T-Bills. ~0% is better than whatever negative inflation is going on. So as the gap between inflation and the interest rate drops, more and more businesses and individuals will park their money there. Worse2 yet, as this point is likely deflation, there is extra incentive to hold on to your now appreciating cash or stocks of T-Bills, reducing further spending/consumption and investing in private enterprise, which can cause a deflationary spiral. A bad positive feedback loop.
2. We'll assume economic recession is bad. There are counter arguments.
So here we see another angle of the problem. The ZLB means the Fed can't incentivize investment over cash holdings, and worse yet, can cause consumption to slow down creating a vicious cycle.
Part 3
If we combine parts 1 and 2, we have side of the big polygonal conundrum. If a lower inflation rate raises the ZLB, and deflation can push the ZLB above 0% nominal (like, the technical number) interest rates, and if this can create a deflationary feedback loop, the zero lower bound can continue to get worse and worse, further exacerbating the problem. Now we have not one but two variables causing the feedback loop! It's not infinite, of course, because at some point someone's gotta spend their money on something. Necessities like food, worn out clothes, etc, but also someone's going to want a new home, a new TV, a new modem, and waiting for prices to drop isn't going to be worth it. But that point will be after our economy shrinks and shrinks to the point of massive unemployment well above today's and other things that hurt people a lot.
Still with me?
Part 4
The above double feedback loop in part explains the nature that a drop in aggregate demand above the ZLB means a drop the overall economy, but the same drop in demand below the ZLB means a much bigger drop in the economy.
Part 5
There are a few reasons we, fortunately, never hit the deflationary death spiral in the latest economic crisis. The first is "anchored expectations." The Fed has been so good at controlling inflation during the Volcker-and-especially-Greenspan era that people have come to believe that inflation is more or less a given at its current rate of ~2%. The second is that despite the deflationary pressures which could change peoples' minds, fears of inflation by due to the stimulus and QE and effectively interest free bank loans put inflationary pressure on the economy. These opposing factors, combined with the first element, served to keep inflation steady.
So while the worst effects of the ZLB were largely mitigated, we are still hampered and harmed by it.
Finale (drumroll)
Because today were are below "long run equilibrium" which means we are not meeting our annual historical GDP growth rate of about ~2.5%. Interest rates are at zero and the Fed keeps doing alternative measures to boost aggregate demand in the economy like special loans to banks and buying up risky assets above their market/firesale prices. Meanwhile political gridlock meets economically misinformed Congresspeople makes fiscal stimulus an unlikely reality.
The Fed still has many tools under its belt but a simple, immediately effective, no-money-spent stimulus would be to simply announce it will pursue, say, a rate of 4% inflation per year. Because the Fed is totally capable of this, expected inflation would change very rapidly and would result in more people turning from cash to investment and consumption. In turn this would boost employment which would boost consumption further. In other words, it would speed the recovery and rate of economic growth, something we could use, since this is one of the slowest and most precarious recoveries America has ever seen.
We don't want to be like Japan, whose recovery was so slow, their long run equilibrium growth dropped, more or less permanently.
