The New Inflation Debate

So, apparently, the great econoratzi have been having a brand new discussion about inflation.  Paul Volker, whom I usually admire, wrote in an Op-Ed in the Times yesterday, damning the idea before it got out the gate.  Volker is roundly credited with getting rid of the 1970s staglfation brought on by slow growth and high unemployment.

Let's begin at the beginning.  Inflation is currently, and has been for over a decade, at incredible lows:
2001 = 2.83 Bush, G.W.
2002 = 1.59
2003 = 2.27
2004 = 2.68
2005 = 3.39
2006 = 3.24
2007 = 2.85
2008 = 3.85
2009 = -0.34 Obama
2010 = 1.64
Inflation, as tracked above, does not include what they call Headline inflation, which I've written about in the past.  It's a basic market basket of goods that does not include objects that have temporaral fluctuations due to external causes, such as drouts, pestilence, hurricanes, fires, real act of god type shit.  Of course there are other factors which influence those goods too, and demand from third and second world countries is now beginning to hit its stride.  So when NPR reported this morning that food prices have gone up nearly 4%--this is not the inflation that gets tracked by the Fed, or by most inflation tracking indexes.

Moving on.  We all know why inflation is bad, we've all seen the pictures from Weimar Germany, or Russia during the 80s and 90s, wheelbarrows of cash to go to the grocery store.  Governments have one basic way to control inflation, through their Central Bank.  The U.S. did not always have a central bank.  It's been a consistent war.  We had one, then we didn't have one, then we had it again. People don't like Central Banks for the same reason they hoard gold.  The Central Bank issues currency, and as such controls the value of said currency.  They can also withdraw currency, by retiring treasury bonds early, or by not issuing them at all.  This is the only thing the Fed can do really.  It controls interest rate by buying, selling, and creating new bonds.  Quantitative Easing, the Discount Window, other things the fed is known for, can both be folded into this concept.

Given that interest rates are so central to investing and money flow, it became apparent, fairly early on that the Fed can exercise enormous power on the economy.  This makes them an exceedingly cautious entity, which in turn makes those who watch it, desperately follow every inflection, nuance and word choice in their carefully worded statements.  Three years ago, in the heart of the crisis (though even before the crisis) the Fed lowered interest rates to almost zero in an effort to stimulate the economy.  With low interest rates, companies can borrow cheaply, goes the theory.  And with cheap money will go investment, new factories, jobs created, etc.  This has simply not worked out.  For starters, as I said, before the crisis, the free wheeling 2000sandsies the rate was at near zero lows already.  Why?  When the money keeps rolling in, you don't ask why.  Simply, the Fed was in Bed with Wall Street.  The Fed has for three years kicked the can down the road and kept interest rates at historic lows, on the premise that when growth comes, at least it will come cheaper.

Now, with Congress deadlocked, and the President unable to do much until the next election, people are looking again to the Fed for guidance.  Afterall, the Fed is controlled by 12 men, sometimes 16, and getting a quorum of 12 dudes, is a hell of a lot easier than getting nearly 600 of the most contentious, often ignorant, and certainly ignoble bastards to agree on anything is pure fantasy.  But what can the Fed do?  It's entire database of knowledge has shown that lowering interest rates and increasing the money supply is the only thing it can do to the economy.  And interest rates are already at zero.  The answer is two things:  1)  Go for another round of quantitative easing (i.e. inflation) or 2) raise interest rates.  They've done 1) with only marginal effect, and a ton of whining, including a death threat from Rick perry, and there is simply no substantive data on what would happen if they did 2) in the middle of a recession.

About three months ago, they chose a middle ground.  They threatened to raise interest rates, in two years.  As I said, so nervous about the Fed are we, that a mere threat to raise interest rates, immediately unleashed a firestorm of criticism.  From even the one dissenting Fed Director, the most conservative, the Federal Reserve of Minneappolis.  I don't know why Minnesota has a federal reserve bank, really I don't.  Not the most exciting state in the union.  Anyway, the purpose, as I understand it, of this threat, was to tell businesses--get on with it.  You're not going to have this great interest rate forever.  Interestingly, the take away of one economist on NPR this morning was to say, "oh great, things will be the same for the next two years, no need to rush."  That's a paraphrase of course.  I did not take this away at all.  If a company is planning a merger, or a to ramp up production, it will take at least six months, if not a full year of planning.  That said--it's all hay anyway, because the Fed really only said it might raise rates in two years.

My apologies my friends, you wanted the NEW debate, and we've only just got here.  The new debate is that some (very few) economists have been suggesting that we actually let inflation rise.  The rationale is simple.  Low inflation is great for people who own debt, because most debt is locked in, mortgage rates, tuition loans, etc.  That means the debtee gets almost a real dollar for every dollar owed.  Add inflation and suddenly, the debtor has more money to pay the loan payments, which per agreement, remains the same.  This is an interesting thought--and for those following the European crisis, is the central problem that Europe faces--they're out of money.  If Greece was on the drachma, they could devalue their currency, and therefore avoid default.  It wouldn't look great, and it would cause massive inflation, but the inflation could be fixed, and it's still better than default.  And the bondholders would still get paid--to be sure, they'd be getting cents on the dollar--but again, still better than default.  And it's not permanent.  A ten-year bond could well rise in value after two years of an inflationary period.

Volker rang out yesterday with condemnation stating that inflation, is afterall, very hard to control.  And it could easily get built into the system.  Such that raising inflation to 3 or 4% wouldn't eventually do much, and we would be tempted to allow inflation to raise again.  Another economist on NPR this morning said much the same, that for rising inflation to accomplish its aim, it would have to go as high as 10-15%, which is indeed, a very dangerous level.  The highest inflation has been in 60+ years was in the last year of the Carter administration (when Volker was appointed) and that was a whopping 13.58%.

Anyway, it's an interesting idea, and the only point I wished to make about this whole thing is that it seems to me that interest rates being near zero, no longer has the stimulative effect that it's credited with.  The rate should get raised, and the rate should fluctuate naturally with the economy, so that it remains a valuable tool when necessary.