Sorry, but there’s way too much hot air being blown around on this inflation question. Specifically, there is too little effort to reconcile the views of Krugman (no inflation), Taylor, Meltzer (hyper-inflation), and others.
Krugman has the much stronger argument regarding the mechanics of inflation. Persistently problematic inflation requires wage pressure, and the US labour market is sufficiently competitive that wages will largely be driven by the output gap. (Note: that was not necessarily the case in the 1970s, when labour contracts often included inflation indexing.)
What’s less clear is whether the Fed desires a period of moderate-to-high inflation, and if not, whether the Fed will nonetheless have difficulty tightenting monetary policy when that becomes appropriate.
I’m not convinced that politics will lead us to monetise our debt because other political choices would be more difficult. I suspect, though, that Bernanke and his Fed colleagues have raised their estimates of optimal inflation. Confirming Japan’s experience, conventional monetary policy has proved to be weaker than most monetary economists believed, which suggests that slightly higher inflation and nominal rates are warranted during good times in order to give the Fed more room to manoeuvre during a downturn. Put another way, the Fed does not want to put itself in a position where a bad recession raises the specter of hitting the zero bound again.
While evaluating the inflation arguments of Krugman, et al, at least four points are worth noting.
1. Different theories of inflation. In April, Bloomberg quoted Larry Meyer:
The Fed is “running a laboratory experiment” on what drives inflation: the money supply or the output gap, says Laurence Meyer, a former Fed governor and now vice chairman of St. Louis-based Macroeconomic Advisers
“How it turns out will do a lot to influence the economic debate,” he says, adding that his money is on Bernanke.
Krugman has long taken the output gap side of this debate. E.g., last year he wrote: “Calvo argues that inflation risks stem mainly from excess liquidity. He’s in good company there, but I won’t join in that chorus. In general, I don’t trust hydraulic metaphors for monetary economics.”
2. Wages vs. prices. The Krugman camp views wages as the key determinant of long-term inflation: as long as the cost of labour is contained, prices of goods and services will also be contained. Others think wages are often a lagging indicator, and therefore pay more attention to goods and services prices themselves, particularly commodity prices.
3. Time frame. In some cases, differing views about inflation risks are more apparent than real. Those who seem to disagree are sometimes talking about different time frames. Economists, and the reporters who relay their views to the public, are often vague about this.
4. Politics. Meltzer is much more worried than Krugman that political pressure will prevent the Fed from raising rates and shrinking its balance sheet rapidly enough once the economy recovers. Rogoff has a different reading on inflation politics. He thinks the Fed will voluntarily allow higher inflation on the grounds that a period of 1970s-style inflation would be helpful in reducing the debt overhang, notwithstanding the longer-term cost to the Fed’s inflation-fighting credibility. Mankiw, from what I can tell, would like the Fed to follow this course, but it’s not clear if he thinks it will happen.
On all of these points, it’s worth remembering Brad DeLong’s advice to be very cautious in disagreeing with Krugman:
If the past decade has taught me anything, it has taught me that mistakes are avoided if you follow two rules:
- Remember that Paul Krugman is right.
- If your analysis leads you to conclude that Paul Krugman is wrong, refer to rule #1.
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