Sunday, November 23, 2014

Inflation Is Still the Lesser Evil

CAMBRIDGE – The world’s major central banks continue to express concern about inflationary spillover from their recession-fighting efforts. That is a mistake. Weighed against the political, social, and economic risks of continued slow growth after a once-in-a-century financial crisis, a sustained burst of moderate inflation is not something to worry about. On the contrary, in most regions, it should be embraced.

Perhaps the case for moderate inflation (say, 4-6% annually) is not so compelling as it was at the outset of the crisis, when I first raised the issue. Back then, against a backdrop of government reluctance to force debt write-downs, along with massively over-valued real housing prices and excessive real wages in some sectors, moderate inflation would have been extremely helpful.

The consensus at the time, of course, was that a robust “V-shaped” recovery was around the corner, and it was foolish to embrace inflation heterodoxy. I thought otherwise, based on research underlying my 2009 book with Carmen M. Reinhart, This Time is Different. Examining previous deep financial crises, there was every reason to be concerned that the employment decline would be catastrophically deep and the recovery extraordinarily slow. A proper assessment of the medium-term risks would have helped to justify my conclusion in December 2008 that “It will take every tool in the box to fix today’s once-in-a-century financial crisis.”

Five years on, public, private, and external debt are at record levels in many countries. There is still a need for huge relative wage adjustments between Europe’s periphery and its core. But the world’s major central banks seem not to have noticed.

In the United States, the Federal Reserve has sent bond markets into a tizzy by signaling that quantitative easing (QE) might be coming to an end. The proposed exit seems to reflect a truce accord among the Fed’s hawks and doves. The doves got massive liquidity, but, with the economy now strengthening, the hawks are insisting on bringing QE to an end.

This is a modern-day variant of the classic prescription to start tightening before inflation sets in too deeply, even if employment has not fully recovered. As William McChesney Martin, who served as Fed Chairman in the 1950’s and 1960’s, once quipped, the central bank’s job is “to take away the punch bowl just as the party gets going.”

The trouble is that this is no ordinary recession, and a lot people have not had any punch yet, let alone too much. Yes, there are legitimate technical concerns that QE is distorting asset prices, but bursting bubbles simply are not the main risk now. Right now is the US’s best chance yet for a real, sustained recovery from the financial crisis. And it would be a catastrophe if the recovery were derailed by excessive devotion to anti-inflation shibboleths, much as some central banks were excessively devoted to the gold standard during the 1920’s and 1930’s.

Japan faces a different conundrum. Haruhiko Kuroda, the Bank of Japan’s new governor, has sent a clear signal to markets that the BOJ is targeting 2% annual inflation, after years of near-zero price growth.

But, with longer-term interest rates now creeping up slightly, the BOJ seems to be pausing. What did Kuroda and his colleagues expect? If the BOJ were to succeed in raising inflation expectations, long-term interest rates would necessarily have to reflect a correspondingly higher inflation premium. As long as nominal interest rates are rising because of inflation expectations, the increase is part of the solution, not part of the problem.

The BOJ would be right to worry, of course, if interest rates were rising because of a growing risk premium, rather than because of higher inflation expectations. The risk premium could rise, for example, if investors became uncertain about whether Kuroda would adhere to his commitment. The solution, as always with monetary policy, is a clear, consistent, and unambiguous communication strategy.

The European Central Bank is in a different place entirely. Because the ECB has already been using its balance sheet to help bring down borrowing costs in the eurozone’s periphery, it has been cautious in its approach to monetary easing. But higher inflation would help to accelerate desperately needed adjustment in Europe’s commercial banks, where many loans remain on the books at far above market value. It would also provide a backdrop against which wages in Germany could rise without necessarily having to fall in the periphery.

Each of the world’s major central banks can make plausible arguments for caution. And central bankers are right to insist on structural reforms and credible plans for balancing budgets in the long term. But, unfortunately, we are nowhere near the point at which policymakers should be getting cold feet about inflation risks. They should be spiking the punch bowl more, not taking it away.

Read more from our "Imperfect Indicators?" Focal Point.

  • Contact us to secure rights


  • Hide Comments Hide Comments Read Comments (21)

    Please login or register to post a comment

    1. CommentedParrain Boursorama

      I agree with much in White’s analysis. As he stresses, the most fundamental driver of financial instability is the ability of fractional reserve banks (and shadow banking systems) to create credit and money, and thus to inject additional spending power into the economy.

    2. CommentedEdward C D Ingram

      What we really need is a new set of debt structures.

      If those are put in place inflation will not do much damage if any and recovery will be relatively quick.

      But I get ahead - there is a lot of work to be done.

      I have laid the foundations - now you guys have to build on them.

      I continually try to make my work easier to get a grip on, but at the end of the day you just have to put everything down and study it.

      You will discover that the current debt structures used for housing and government debt are the major sources of economic and financial instability and you will learn how to alter that so that we can all move on.

      The maths of lending etc is here:

    3. CommentedRobert Malthus

      "... as it was at the outset of the crisis, when I first raised the issue."

      Sounding a bit like Krugman, aren't we?

      Why do we suffer these frauds? Why, oh why, do we continue to put faith in these phony "experts" even after they are exposed as buffoons? [google Reinhart And Rogoff]

      Let's invite Nassim Taleb into this discussion. Now that would be interesting!

    4. CommentedRobert Lunn

      Isn't too much being made of this Fed "taper" discussion? I guess we all listen careful but hear different things from the Fed. What I hear was more of "if things are improving we could begin to taper off purchases". The numbers collectively seem to indicate GDP is breathing a little harder mostly do to the carry trade and subsequent boosting of asset prices. Corporate and mortgage refinancing to be sure but housing reflects more institutional buying to rent or flip.
      Fiscally, nothing but headwinds. Wages are punk too. If there is a surprise it seems to be 2nd half fiscal contraction as a result of sequester cuts and slow growth around the world.
      Most of the money being made is going to those who are engaged in the carry trade in some form. More link a "mile deep and an inch wide", to turn the phrase over.

    5. CommentedMichael Harrington

      I would disagree to the extent that stable prices are a healthy foundation for any economy in the long term. Inflation is like slow-growing cancer that infects and distorts all price signals, increasing the chances that the economy becomes more vulnerable to unforeseen shocks. Deflation is like radical surgery to save the patient, but inflation that gets out of control has only one cure - a downturn so severe and unstoppable that the people are destroyed to save the economy. The economy would be better served by small adjustments of creative destruction that are forced through monetary restraint. Our current problems are the natural result of never wanting to pay the consequences for our mistakes. Number one culprits are the financial and public sectors.

    6. CommentedTomas Kurian

      The goal of QE is to produce inflation, as a crude and imperfect way of getting rid of savings glut. As there is not yet possibility for negative retail interest rates, the only way to achieve this is through inflation, which is not so easily invoked at all.

      After all, it needs to rise prices and wages ( across the board) and this is indeed cumbersome and requires broad coordination and willingness of capital owners, who in agreeing to pursue this strategy also agree to obliteration of their own saved profits, which is against their interests.

      Therefore inflation is hardly seen.

      Even if this approach worked, it would seriously harm small savers, people before pension and so the results would be muted at best.

      However, there is a way how to handle this problem without indiscriminately hurting small savers:
      Upgrade of our financial system to fully digital and introduction of tax on deposits (direct capital tax).

      That way central banks could introduce negative RETAIL interest rates and the problem of zero lower bound would be solved.

      The mechanism for this is described in my work:, chapter 16.

      By introducing such measure, we could alter consumer spending/saving habits without need for so crude method as inflation, without need for excessive QE, which is hardly working anyway.

      Introduction of fully closed circle of capital which enables its recycling through direct tax on deposits is an arrow, which is currently missing in central bank´s quiver and causing all the problems.

    7. CommentedAdam Harper

      It's seems to me that continued easing is not at present an effective way to achieve inflation. If the opposite strategy were adopted and the Fed truly began to take actions to end QE, interest rates will rise and banks may finally find the incentive to take on the risks and dip into their excess reserves and pump some money out into the real economy. Given the obscene amount of reserves just sitting in the Fed's books, ending QE should be done in baby steps.

    8. CommentedMark Pitts

      Higher inflation would only destroy more savings of individuals, pension funds, and retirees. Individual investors are taking too much risk in a reach for yield. Professional investors are ready to bolt at the first sign of yield increases. QE is no longer working. Things have changed since 1937 - the public is no longer ignorant.

    9. CommentedJonathan Kniss

      Rogoff is wrong. Inflation is not the lesser evil because of all the unintended consequences of QE.
      1. Boosting asset prices gives the appearance of wealth but does nothing to add to the productive capacity of the economy. Capital spending is not trending up because those who are responsible for that spending are not fooled by the temporary effects of the Fed's artificial stimulus.
      2. QE has enabled the US government to continue on an unsustainable fiscal path. In the longer term, all this Fed-owned debt will have to be sold or rolled over and this will occur at a time when the US is even more fiscally challenged due to the explosion of SS/medicare. At that point, there will be no saving the dollar, regardless of the policy pursued and disorderly inflation will result.
      3. QE is a massive transfer of wealth from the prudent to the profligate, from the asset-poor to the asset-rich, from the hapless younger generation to the self-indulgent boomer generation, from the producing sectors of the economy to the parasitic (banking) sector of the economy. The incentives are truly perverse.
      4. QE has caused a return to the same behaviors that got us into trouble in the first place. Private sector leverage is rising, as is total leverage. Did we learn nothing from the last crisis?

      By delaying the inevitable, we are only making the next reckoning all the more painful.

        CommentedJose araujo

        Sorry, but I think you are also Wrong. The problem isn't QE, the problem is the lack of fiscal policies that must follow the QE that should be aimed at developing internal demand. The old New Deal sfuff, you know, the one that got us out problems last time.

        CommentedRobert Lunn

        Mostly agree but the transfer is going to the top through the Fed actions. The have not crowd is doing worse. I can assume you mean savers are taking it on the chin, which is true. Others who asset and liability match like pension funds are hurt too, except their existing assets are inflated arguably.
        Doesn't it seem like Dr. Rogoff is managing his image here a little? He is taking heat for giving the austerity crowd cover; unjustifiably maybe, so he comes up with this angle.?

    10. CommentedJames Daniel Paul

      I agree with Prof Kenneth Rogoff, inflation with optimism have been very useful across countries. In India, while the government was trying to pump funds through the projects...the central bank always had a strong support from the industry which attempts to keep the interest rates lower.

    11. CommentedProcyon Mukherjee

      The world is replete with wrong examples on inflation, contrary to the Central bank's efforts to raise inflation expectations; BOJ efforts have so far yielded negative results as 2012 inflation at -0.1% has now dipped further to -0.7% in April 2013. The U.S. example is no different with inflation barely improving.

      The real reason is that money supply has to move to goods and services to spark off inflation, whereas that is hardly the case with M2/M0 slowing down instead of rising in the last three years.

        CommentedJose araujo

        Nop, you would have inflation if you were in a full employment situation, which is a good thing.

    12. CommentedKen Fedio

      Actually, I like El-Erian on this question: the Fed used to be there to squelch inflation; now they're there to invent growth. We all know what happens when a system begins to feed upon itself; it creates the most beautiful distortions and asymmetries.

    13. CommentedHenry Rearden

      Mister Rogoff is about to get his inflation. Look at it this way. If you were a bank, what would be your excuse for not lending money to an Exxon-Mobile? There isn't one, is there? The American Petro-chemical industry is about to take full advantage of two things, low interest rates and cheap natrual gas. They will borrow money for new plants and equipment. They will spend that money on, guess what, noe plants and equipment. To do that, they will find that they are trying to hire crafts and skill that are in acutely short supply. Guess what that means!

    14. CommentedMarc Laventurier

      Someone should fund an academic position, the Rube Goldberg Chair of Kludgenomics, 'cause, ya know, “It will take every tool in the box to fix today’s once-in-a-century financial crisis.” Comes with a built-in whoopy cushion.

    15. CommentedFrank Hollenbeck

      rom Mises, plain talk, 1948, talking about the post Malthus Say debates of the early 1800s. "Those authors and politicians who made the alleged scarcity of money responsible for all ills and advocated inflation as the panacea were no longer considered economist but "monetary cranks" the struggle between the champions of sound money and the inflationist went on for many decades. But it was no longer considered a controversy between various schools of economist. It was viewed as a conflict between economist and anti-economist, between reasonable men and ignorant zealots." With this article Rogoff has clearly put himself in the camp of the ignorant zealots!

    16. CommentedG. A. Pakela

      There is no evidence that the QE policy works. While interest rates have certainly dropped for the most credit-worthy of borrowers, savers have been wiped out with respect to receiving any kind of positive return, and they are even losing money, as inflation exceeds the interest rates. So the so-called monetary stimulus as represented by QE has been at best a zero-sum gain. If it were otherwise, the M2 growth would be high, and thus reflective of its success. Instead, M2 growth is virtually nil, suggesting that no new money is being created. QE policy itself has not resulted in raising the money supply, but it has increased the potential for volatility in markets. Only the actions of borrowers and lenders can increase money supply.

    17. CommentedRobert O'Regan

      Wait a minute " ...If the BOJ were to succeed in raising inflation expectations, long-term interest rates would necessarily have to reflect a correspondingly higher inflation premium........if interest rates were rising because of a growing risk premium, rather than because of higher inflation......." run that by me again...." if the chicken came first and then the ..wait..if the egg came along and then the chicken...." I love this sort of stuff...