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(Part of) The Case for Higher Inflation

By Matthew Yglesias on January 17, 2010 at 11:28 am

"(Part of) The Case for Higher Inflation"

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This whole crisis has made me think, in a variety of ways, that western policymakers made a mistake with regard to inflation back in the 1990s. In the seventies, the inflation rate was very high and increasing. It was a big problem. In the early 1980s, policymakers largely solved this problem and got inflation down to a much-lower and stable rate. But then having succeeded at this they then went on to push the inflation rate even lower which was done for reasons that were never articulated in a very clear way. This in turn resulted in unusually low nominal interest rates of various kinds, which I’ve come to believe have had a lot of undesirable consequences. For example, the low pre-crash nominal interest rates have meant that the Fed hasn’t been able to do very much with its conventional monetary policy post-crash.

But who am I to say? Andy Harless, by contrast, has a PhD and everything:

But the Fed’s hands were tied. The Fed dropped its federal funds rate target by 5 percentage points in the year and a half following the onset of the financial crisis, and that was as far as conventional monetary policy could go. If the inflation target had started out at 4% instead of 2%, and the federal funds rate had started out at 7.25% instead of 5.25%, the Fed would have had a lot more ammunition. Moreover, the market would have known that the Fed had more ammunition, and investors would have been more confident in the Fed’s ability to minimize the economic impact of the financial crisis, and this would have made financial instruments less risky and thereby ameliorated the financial crisis itself.

You may therefore add my name to the list of those who blame past Fed policies for the severity of the recent crisis – but not because the Fed allowed a bubble to develop. Quite the contrary. The Fed eventually popped the previous bubble – the tech bubble – not because it was a bubble but because the economy was nearing the overheating stage, and the inflation rate risked eventually rising back to levels of a decade earlier. In my opinion, the Fed was wrong to pop that bubble. The Fed should have let the economy overheat, for a while, and let the inflation rate rise. (Higher future product prices might, in fact, have turned out to justify stock valuations that proved to be, in the retrospect of the path actually taken, unreasonable: a bubble is a slippery thing.)

I would like to see more commentary on this matter from smart and informed people before I say I’m taking this account to the bank. But it seems to me to be an obvious enough question to ask especially since there are a variety of other reasons to think that something like a 3-4 percent inflation rate would be more desirable than a 2 percent inflation rate.

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