Faster Inflation Would Help…Really!

October 27th, 2013 at 5:34 pm

Very interesting piece in today’s NYT on how more inflation would actually be helpful right about now.  That’s probably counter-intuitive to a lot of readers so let me elaborate.

To be clear, none of us would be calling for faster price growth were it not for the fact that inflation is really low.  This chart from the NYT piece plots the price measure that the Federal Reserve watches most closely—the core PCE—which was last seen growing at around 1.2%, technically termed bupkis by seasoned inflation watchers.  This is clearly a function of weak demand, hardly any wage pressures, and no pricing power by firms.

But if such persistently low inflation is a symptom of weak growth, it’s not exactly obvious that faster inflation itself would lead to improved growth rates.  Isn’t this mistaking an outcome variable for an input variable?

In fact, there are various ways in which higher inflation can help at a time like this.  Most importantly, it lowers the real rate of interest.  True, interest rates are low right now—the one controlled by the Fed is about zero.  But last I checked, if you look at historical relationships between economic variables and interest rates, we actually need borrowing rates to be less than zero, and that’s where higher inflation comes in.

The real interest rate is the actual, or nominal rate, minus the rate of inflation.  So the only way to jam the real rate down to where it needs to be—i.e., in negative territory—is through higher inflation.  That could motivate investors to undertake new projects, from factory expansions to a home loan for an addition on your house.

Second, higher inflation reduces debt burdens (since debts are typically repaid in nominal dollars) and, as a few retailers point out in the piece, it also increases profit margins.

I’m quoted in there as supporting all of the above points, but still being worried about the impact of higher prices on real wages.  So let me say a bit more about that.

On net, faster inflation would help shake the macro-economy out of its slog so I’m for it.  But it’s not costless.  It hurts those on fixed incomes, hurts creditors (the flipside of helping debtors), and risks unmooring well-anchored inflationary expectations (though these days most of us are more worried about deflation than spiraling inflation).

And, all else equal, it would also reduce real wages.  Most recently, the hourly pay of mid-wage workers has been growing at around 2% per year with inflation running at about 1.5%, so slight real wage gains.  Take inflation up a point and unless nominal wages accelerate as well, we’re now talking about real wage losses.

However, all else is almost never equal.  Let’s reflect for a second on how wages are determined.  For macro-types like economist Larry Ball, with whom I discussed this and who thinks deeply about such things, the growth in nominal wages is simply the growth real wages plus inflation.  Real wage growth is itself a function of real things, like productivity growth and/or bargaining power, and inflation, at least in the long run, is determined by the Fed.

So in this formulation, higher inflation just leads to higher nominal wage growth—real wages are not much affected.

Others argue that with faster inflation, firms can adjust to weaker demand not by reducing nominal wages, something they typically avoid (sticky nominal wages), but by allowing real wages to fall.  In this view, higher inflation allows for an adjustment that’s unavailable at low inflation.  In fact, it’s similar to the zero-lower-bound (ZLB) problem that higher inflation solves on the real interest rate side, but in the wage case the ZLB is replaced by the fact that firms don’t like to lower nominal wage rates.

As my quote in the NYT piece suggested, I worry that higher inflation could at least temporarily lower real wages, though I still think its benefits would outweigh its costs right now.  Moreover, when we’re talking about how macro maps onto micro these days, we can’t ignore distributional outcomes.  Dynamics that look good from an average perspective don’t necessarily look that way from the low- or middle-end of the wage spectrum.

A quick look at such relations over time is revealing.  Using annual data (because my distributional wage data are annual), I regressed the (log) change in nominal wages on the (log) change in the core PCE deflator (lagged one period) and the unemployment rate.  The figure below shows the inflation coefficient (statistically significant in each case) for the 10th, 50th (median), and 90th percentile wage.

As Ball suggested, nominal wages do grow faster when inflation is faster, but less so for lower wages (though see note below re significance).*  So while I’m solidly in the camp that higher inflation would help right now, I still want to keep an eye on its real impact on wages at different percentiles.  Low-wage workers are particularly vulnerable to this “solution.”



Source: See text.  My calculations using data from BEA, BLS, and EPI for nominal wage data.

*BTW, you’re right to worry that the coefficients on inflation are less than one, suggesting a real loss, but a Wald test suggests they’re actually statistically indistinguishable from one; the same test also fails to reject the hypothesis that the coefficients are the same, so again, less to worry about here than meets the eye.  On the other hand, this is just a little, toy model so not exactly the last word on this gnarly issue.

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8 comments in reply to "Faster Inflation Would Help…Really!"

  1. Tom in MN says:

    You also did not mention that higher inflation helps with debt: your mortgage payment is in fixed dollars, so more inflation drops your payments in real terms. While those on fixed incomes might be hurt, Social Security is inflation adjusted and if we could get the minimum wage to be also tied to inflation (I think this was part of the President’s proposal), this would make a lot of low income folks less bothered by inflation.

    I think the Fed should be aiming for 4% inflation. The “high” levels they talk about are 2.5%, which does not seem like much over 2 given the noise in the measurements. This would give them a lot more room to avoid the zero lower bound in the future. And with the problems getting fiscal responses to recessions, giving the Fed, which as you recently said is the only functioning institution left, more room to work with conventional monetary policy would seem to be a good idea. I think the Fed can just decide to aim for this level if they want. A statement to this effect would also work well with their current usage of forward guidance to change expectations.

  2. masaccio says:

    You don’t even mention retirees. Higher inflation coupled with Obama’s favorite cut Social Security Plan of Chained CPI will cause major damage to them, and increase the burdens on their children.

    Higher inflation while the Ded keeps interest rates at 0% means that small savers are completely screwed.

    But who cares about them, right?

  3. smith says:

    There two very worrisome parts to the discussion of higher inflation.

    One is most economists have no plan to deal with a functioning non-recessionary economy.

    There is no protection against usury since 1978 The situation is worse because banking is more consolidated, nearly all national. The decision referenced above overturned protections that were in place since the colonial era (meaning 1700s for those from the east coast).

    There is no bargaining power to match inflation in union contracts due to decline of manufacturing and prevention of organizing office employees (they’re all exempt from labor laws). When unions had critical mass of 1/4 to 1/3 they pushed up the wages of those in offices above them, and non-union wages under threat of unionization, and dragged up those behind them likewise.

    Monopolies and oligopolies use inflation to raise prices irrespective of their costs, even to their own long term detriment, while blaming rising labor costs. In threatening to close factories they’re constrained by downwardly nominal wage rigidities, which disappears with normal inflation.

    Restore state usury law, end exempt status, break up monopolies, the too big to fail banks, then we’ll talk.

    The other worrisome part? Inflation talk distracts from needed stimulus measures, foreclosure relief, free college for all, renewable energy research.

  4. BL Davis says:

    You wrote: Real wage growth is itself a function of real things, like productivity growth and/or bargaining power, and inflation, at least in the long run, is determined by the Fed.

    First:I have numerous graphs, likely including one from you, that show that the top 1% gained almost all the benefits of productivity for the last 20 years or so while the bottom 50% or so received no (or almost no) increase in wages from productivity.

    Second: the number of unionized workers has fallen steadily for at least 2 decades along with the bargaining power of these workers and their multiplier effect..

    Third: the number of right-to-work states has increased resulting in lower wages (declining wages) for workers, often causing them to drop into a lower income percentile

    Therefore, Absent benefits from productivity and unions,why would you assume that a bit of inflation via the Fed would be good for wages? Oh, that’s right, you did admit inflation would not help those at the lower end of the wage spectrum.

    Doesn’t that result in yet another transfer of wealth from the poor to the 1% ?

    • Jared Bernstein says:

      All good points–I said, “that’s how macro-types” view real wage growth, though to be fair, they also recognize bargaining power, which I think is a huge factor in the distributional results you’re describing.

  5. nkd says:

    Why higher inflation is threat for countries other than US.??