I recently ran across a couple of tweets that look at the pros and cons of inflation. This one seems to accept the Philips Curve as a way of framing the issue:
This one opposes higher inflation:
I am not a fan of either tweet.
It’s true that using monetary policy to suddenly move inflation up or down can produce a negative short run correlation between inflation and unemployment. But we learned in the 1970s that the Philips Curve is not a useful way of thinking about inflation, for all sorts of reasons. Rather than approach the inflation issue on an ad hoc basis, we need to think about an optimal monetary policy regime. The analysis should be time consistent.
For instance, suppose you adopt a more expansionary monetary policy to avoid a rise in unemployment, and this leads to higher inflation. That sounds like a pretty clear example of a policy trade-off, right? Actually, this trade-off is largely illusionary, as it ignores the long run effects. If the more expansionary monetary policy reduces unemployment then you have two choices, continue with a higher inflation rate forever, or bring inflation down at a later date.
With a permanently high inflation rate, you are buying a few years of lower unemployment against an infinite number of years of higher inflation, not at all what readers of the tweet poll might have assumed. If inflation is reduced after remaining high for just a couple of years, then you are merely postponing the high unemployment for a few more years. Again, that’s not what the poll question seems to imply.
The second tweet is also misleading. If the Fed raised the target inflation rate from 2% to 3%, the public would hardly notice. That’s because the Fed achieves its goals by influencing aggregate demand. Because AD affects both wages and prices, modest demand-side inflation is not all that unpopular. The current inflation is highly unpopular because supply shocks are reducing living standards (especially food and energy). But using monetary policy to change the inflation target from 2% to 3% would have no impact on that sort of highly unpopular supply-side inflation.
To be clear, I don’t support raising the inflation target from 2% to 3%, which I see as a slight net negative. But the current unpopularity of inflation has little bearing on the merits of that proposal. Inflation was roughly 4% during 1982-90, and it was not a big issue. If inflation had been 3% during 1982-90 it would have been an even smaller issue.
A better reason to keep inflation at 2% is that monetary policy is more effective when it has credibility. A credible monetary policy is better able to prevent business cycles. Suddenly shifting to 3% inflation would reduce the Fed’s credibility (which is already on shaky ground.) That’s why it’s a bad idea.(1 COMMENTS)