On Inflation

Among liberal economists, there is widespread belief that much more should be done to deal with high unemployment. Another fiscal stimulus is popular though everyone is resigned to the fact that it won't happen with the current Congress (and mute president).

Since fiscal policy is not an option, many liberal economists want more efforts on monetary policy. Granted, the federal reserve and Ben Bernake have been doing a lot, but to little effect on unemployment. What everyone seems to be saying then is that while the fed is meeting one of its two mandates (inflation) but not its other mandate (unemployment) it should do more towards the mandate it isn't meeting. The way to do this is the fed can relax its strict price stability goal and allow inflation to rise a bit in order to bring unemployment down.

The best articulation of how to achieve this is from Justin Wolfers and Betsy Stevenson. I won't explain it here, though it is very accessible so I encourage you to read it. Instead, I want to look at the things people site in opposition to doing this. There are some reasonable concerns.

First, Paul Volker, who broke the back of inflation during the early 1980s while Fed chair under Reagan, is worried that once you use inflation as policy, the expectations become ingrained. This makes it less effective as a policy in the future and also more difficult to control.

Ben Bernake echoes this when he talks about his reluctance to damage the feds reputation for price stability. If one time the fed diverges from its rigid price stability, the market will be less convinced of their price stability goals and therefore preventing inflation would be more costly.

The way Volker articulates it is more convincing. I think I still agree with Paul Krugman on this one - why worry about a potential problem in the future instead of the actual problem you have now? And yet the more I think about it, the more I wonder if it is dangerous in the long term.

Second, Ben Bernake also seems to think that any extra efforts by the Fed, whether it be QE3 or allowing inflation to rise, would cost a lot but get little in return. For example, letting inflation rise from 2% to 4% might only get a decrease of 0.25% in unemployment. I made up the numbers, but that is how I understand what he is saying. This one is really hard to argue against because I have not nearly enough economics training to say the models he is using are wrong. The best I can do is trust the many economists I read that think this isn't the case.

Third is general uncertainty. Paul Samuelson and Noah Smith make this point. We don't really know whether Volker and Bernake or Krugman, et al are right. Everyone has models. Some have a better track record than others (ie Krugman's liquidity trap), but even those we don't know for sure if they will continue to be right.

So there are real reasons to be cautious about more aggressive monetary policy. These issues all give me pause. I think I continue to lean towards doing more in the face of such terrible unemployment. But there are real risks and we should keep that in mind.