Prepare for Inflation

Paul Krugman provides Dr. Janet Yellen with an endorsement to be our next head of the Federal Reserve.   If selected and confirmed, I predict that she will attempt to introduce 4% annual inflation as a “Goldilocks” means of reducing our deficit while seeking to reduce stubborn unemployment.    For the empiricists who read the RBC, keep an eye on the price of gold and on TIPS bonds.  These market prices will provide clues about fears concerning anticipated future U.S inflation.  It is true that international investors have to “pick their poison” concerning their asset allocation.  U.S Treasury Bills may continue to be a more attractive investment than international alternatives.

Who loses from 4% inflation?  Cash holders, U.S bond holders,  and anyone else (including UC faculty!) whose nominal salary (or pension payments) isn’t indexed to the CPI!  The senior faculty at public research universities will be incentivized to seek out outside offers to keep their real income constant!   Our private sector peers regularly receive cost of living adjustments.

Author: Matthew E. Kahn

Professor of Economics at UCLA.

19 thoughts on “Prepare for Inflation”

  1. I have to say that I am somewhat mystified by how appointing Janet Yellen as chair would convince the Fed’s Board of Governors to suddenly double its inflation target (nevermind actually getting there). Could you elaborate?

    As for cash holders and US bond holders losing from inflation (2% or 4%), that’s kind of the point, as I have always understood it. Having a small, but non-zero inflation rate has (among other things) the purpose of penalizing those who sit on their money rather than investing it.

  2. This would be a welcome change from the current policy of targeting inflation < 2%, targeting unemployment = who cares?

    But Krugman's endorsement carries about as much weight with Obama as Noam Chomsky's would.

    1. But Krugman’s endorsement carries about as much weight with Obama as Noam Chomsky’s would.

      Maybe Glenn Greenwald will jump on board also, which would really be decisive : )

  3. Chicago-trained economist Matthew Kahn tells us that the country must tolerate 7 1/2% unemployment forever in order to preserve the purchasing power of tenured professors at public universities. There’s a guy who’s got his priorities properly ordered.

    1. The thing is, there IS a guy who has got his priorities ordered. According to his worldview, the same worldview he and his ilk wish to proselytize across the world, this is a completely defensible position. His utility is improved by zero inflation, and it isn’t affected one way or the other by mass unemployment.
      Sure the attitude that mass unemployment has no effect on me is the thinking of the sociopath, but that’s the goal of economics, isn’t it — to convert us all into sociopaths.

  4. Katja, I don’t think Matthew wrote that Yellen’s appointment would convince the Fed Board to “suddenly double its inflation target.” Rather, he predicted that she would “attempt to introduce it.”

    And BTW, penalizing savers is most certainly NOT “the point” of promoting a small, but non-zero, inflation target. The point is(are) to promote growth in demand and to shrink the weight of debt.

    There is no purpose in the world to penalizing anybody for “sitting on their money,” since that “sitting” is virtually always simply putting in the hands of somebody else to use it. Back a few years ago, banking really was “banking,” rather than “gambling with somebody else’s money.” It was a boring field, and it didn’t attract most the best and brightest, but it worked quite nicely. I spent some of my income on consumption, spent some of it on capital items (house, most notably), and saved some of it, in case I might have an emergency, or eventually retire. But what happened to my savings? Did I “sit on them?” Of course not. I put them in the bank, where they were lent out at a somewhat higher rate than the interest I earned from the bank, thus providing the bank with a margin for their overhead and profit.

    Sadly, that model is defunct. There is no interest available. However, security is still a major consideration for those of us who have stopped earning. The FDIC and the US Treasury are still our favored depositories for being confident that our money will still be there tomorrow. So now, Katja, as I am 70 years old and have no new earned income, how would you recommend I reallocate my “savings” so that I won’t be penalized for “sitting on them?” Which “investment” would you suggest might provide me a modicum of security, while helping to promote my country’s economic health. Surely not “speculating in the stock market.” That’s not “investing.” It contributes nothing to the creation of goods and services, nor jobs, nor GDP.

    Point me to a new startup company that can use my INVESTMENT to create jobs, produce goods and services, and help my country grow its economy. And maybe, in the process, can provide a little return on my investment, or at least keep it safe from sudden precipitous shrinkage.

    1. Ken, I was specifically thinking of banks sitting on their money, not individual savers. Individuals generally don’t have the expertise and financial infrastructure to know how to lend and to invest money effectively; banks do. Customers should have access to savings accounts, pension plans, or similar financial instruments that allow them to invest money at a rate that roughly matches or exceeds inflation without a whole lot of stress, while banks take care of researching investments, risk pooling, etc.

      Obviously, you generally don’t want a high or even heavily fluctuating inflation rate (which is why I don’t buy into the Board of Governors approving a 4% inflation target).

      But if you think that I am talking about penalizing individual savers, then I believe you’ve misunderstood me (I may very well have not been clear enough). What I was trying to get at is that if it’s beneficial for banks to not lend money (which is what can happen if the inflation rate is too low, zero, or negative), then they may not lend money, and investment will not happen, and there’ll be a lack of growth.

      The problem is that in recent years, banks indeed appear to have started “sitting on money” (typically in the form of excess reserves). You can observe that when you watch the ratios of the M2, the M1, and the M0 money supply. You will note the big increase in the M0 supply (created by the Fed through Quantitative Easing etc.), but no commensurate increase in M2; M2 is normally created by private banks through Fractional Reserve Banking. However, because that hasn’t happened to a sufficient degree, the Fed had intervene as a lender of last resort (for the market as a whole, not individual banks) to inject additional liquidity (via QE).

  5. I heartily recommend Krugman’s blog, linked in the post, to anyone interested in these issues; he deals with them extensively. I personally find him highly persuasive, but if you don’t he will probably lead you to your allies; he links pretty thoroughly to the people he disagrees with.

  6. Matt assumes away the benefits to tenured professors at public universities of improved economic performance leading to enhanced tax revenues. Can you say “partial analysis”? I thought you could.

  7. You know who else “loses” with 4% inflation? Banks and mortgage companies that have fixed-rate loan portfolios. Given how much in profits the financial sector has taken out of the rest of the economy, that may not be such a bad thing.

    1. Yeah, I’ve been anticipating a return of inflation, (Or, rather, an admission that it has returned; I do the shopping in the family, so I know it’s been back for a year or more.) one of the reasons I’ve been desperate to get out of this apartment into a home with a fixed rate mortgage.

  8. “Our private sector peers regularly receive cost of living adjustments.”

    I presume this is some kind of joke?!?

    Or maybe you have a ridiculously restrictive definition of ‘peers’?

    Most workers don’t have any pension at all, much less one indexed to anything. Ivory tower thinking…

  9. Tutoring by Profs. Krugman, Delong, and others, have made me understand the virtues of a slightly higher inflation rate. In other words, I’m with Katja.

    Not just the headroom it gives us when there’s trouble. But also, ethically. We put up with a system in which there is great inequity because it leads to greater growth and wealth for everyone. But that only works if capital is actually invested in new enterprises. And what will force people with capital to do that? Inflation, which will erode the value of their holdings if they don’t do something productive with it.

    2% has, clearly, turned out to be too low as an incentive to invest — and we don’t even have that. 4% sounds perfectly reasonable to me. It isn’t 40% or 400%. It’s very reasonable and moderate.

    Disclosure: Yellen is my late father-in-law’s cousin.

    1. To clarify: I’m not in favor of a 4% inflation target, and I don’t see any evidence that Janet Yellen is.

      The ideas behind a 4% inflation target so far seem to be very speculative, and largely favored by ivory tower economists. As James notes below, Janet Yellen is a central banker first and a liberal second. This means that while she’s likely to be in favor of expansionist monetary policies, she’s not likely to hitch the US economy to an unproven scheme that would constitute a very dramatic change.

      Doubling the inflation target would hardly be a gradual thing; it has a huge number of potential side effects that one has to consider carefully.

      The biggest question marks are wages and pensions, and whether they would keep up with an increased inflation rate. Prices, with a 4% inflation rate instead of a 2% inflation rate, would double every 17.7 instead of every 35 years. The models say that, yes, wages will keep up with 4% inflation due to increased growth, and you’ll get higher employment, too, but whether the models will hold up in reality is another question.

      This is where the rubber meets the road of actual politics, labor laws, and collective bargaining (where it exists). You’ll have to update the minimum wage more frequently, you will have to negotiate pay raises more often, etc. Especially for the bottom income bracket — where workers, particularly in the US, are a rather fungible resource with little leverage — unequal bargaining power could easily lead to a decline in real wages.

  10. This is what my intermediate macro prof said in 1992 when Clinton was leading in the polls. I don’t know why he cared, he was a RBC guy and told us that money doesn’t matter. BTW, do colleges have refunds?

  11. Doers Matthew have any evidence to offer for his canard prediction that Ms Yellen would press for a 4% inflation target? She’s a mildly liberal central banker, with emphasis on the “central banker”.

  12. Kahn says: “Who loses from 4% inflation? Cash holders, U.S bond holders, and anyone else (including UC faculty!) whose nominal salary (or pension payments) isn’t indexed to the CPI!”


    Cost of Living Adjustments (COLAs)
    Once retired, there is an annual COLA every July 1 for eligible retirees. The retiree must have been retired for one full year on or prior to a subsequent July 1. COLAs are based on movement in the Consumer Price Index (CPI) and are not necessarily matched point for point. COLAs range from a minimum of 0.1% to a maximum of 6%.

  13. I work in the private sector, and my nominal wages are 2% higher than they were five years ago. Private sector workers DO NOT receive cost of living adjustments. Every company I’ve worked for has a policy that the base raise for everyone is zero, and any amount over that is based on “merit.” Top-ranked employees _may_ get almost as much as inflation, in a good year, and zero in a bad one. Lower-ranked employees get less.

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