This morning’s report that the U.S. economy grew 2.5 percent in 2013′s first quarter wasn’t horrible, although it was still disappointing. But there was an even more discouraging number Americans should also pay attention to: inflation was a mere 1.1 percent.
While many think low inflation is a good thing, Johns Hopkins economist Laurence Ball published a new paper that argues two percent inflation, which American policy is currently targeting, is too low and that we should be aiming for four percent.
The key factor here is the Federal Reserve’s control over interest rates, which is an important tool for guiding the economy. When the Fed wants to boost the economy out of a recession, it cuts interest rates. When it wants to rein in inflation, it raises them. And for the last two decades, it’s done very well at keeping inflation to a historically low two percent.
That’s doing more harm than good, according to Ball, because it prevents the Fed from fighting economic slumps. The Fed can’t cut interest rates below zero, so there’s a floor on how much help it can provide in a depression, called the “zero lower bound.” And if the Fed keeps inflation low over the long-term, that will leave it less room to cut rates when another recession hits. Ball found the zero lower bound held Fed policy far back from where it should’ve been after the 2008 crash. He also looked at seven other recessions since 1960; in three of them, if inflation had only been two percent, the Fed would’ve also hit the zero lower bound.
Ball calculated that if inflation had been 4 percent going into 2008, giving the Fed two extra percentage points to cut from interest rates, the resulting shot in the arm would’ve increased the size of the economy by 5.9 percent in 2013. More importantly, the unemployment rate would be five percent instead of 7.6 percent — meaning just over four million fewer Americans would be out of work.
Furthermore, history shows that four percent inflation isn’t particularly dangerous. After reviewing the literature on high inflation across countries, Ball concluded genuine economic damage didn’t happen until the rate hit 8 percent. The calamitous inflation Americans remember from the 1970s, for example, peaked at 12.5 and 15 percent. As Matt Yglesias once quipped, Ronald Reagan’s “Morning in America” economic boom came with about four percent inflation.