Thursday, November 24, 2011

A dissection of higher prices...

Inflation is back in the news. Outspoken president of the Minneapolis Federal Reserve, Narayana Kocherlakota, said yesterday that the current monetary policy - attempting to free the stuck labor market - could cause “dangerous” inflation. 

But I wonder if higher prices are really such a bad thing right now. 

The obvious downside is their affect on consumer spending. But, considering the uncharacteristically low levels of core inflation since the recession began, the benefits might outweigh any sticker shock that arises with a modest price increase over the short-run.

Inflation, when it is consistent and predictable, can act like a reset button on the economy. It doesn’t change the potential for production in a country but it does alter the impact of past events on decisions today. The benefits can include less debt pressure on homeowners, more investment by businesses and, finally, a more efficient distribution of wages.

Debt burden: One widely recognized problem with our economy now is deleveraging. Workers are applying more of their income to mortgages and other debt and, consequently, are spending less on trips to the mall. For many, who invested at the height of the housing bubble, the immensity of these liabilities can be nearly insurmountable. Those in the most trouble, who don't qualify for a refinance, can only watch helplessly as their house payments barely make a dent in the principal.

But in an economy with a higher inflation rate the real value of these loan burdens would be reduced. As wages adjusted upward to the new price of money less of a workers’ income would be devoted to debt. 

Investment: Businesses are holding record levels of cash today, which effectively takes it out of the hands of workers and consumers. They’ve made this decision because the current investment opportunities don’t provide a high enough return for the risk. If the value of that cash reduced over time, however, those businesses would have to reevaluate these positions. A bit of inflation would give then the necessary jolt to change that cash into something tangible like a new employee. 

Opponents argue, instead of investing this idle cash in job creating activities, businesses would buy commodities and, as a result, create a new bubble. This is a compelling argument but I think these opponents see our economic situation in too dire of terms – they don’t perceive any good business investments today. 

On the contrary, I think companies are near the point of investment, but remain in a holding pattern because of low demand and uncertainty caused by events like the Euro crisis. A rise in prices would be the spark needed to kick them out of this fruitless circle of stagnancy.  

Job Market: Wages are stickier than consumer prices and don't move so freely up and down. So inflation would initially lower real levels of income as prices moved upward.  Worker contracts would eventually follow, however, and this adjustment period would allow employers to reassess their previous wage decisions. 

As the economy continues to shift, certain sectors have asserted themselves - such as high tech. But because of past labor contracts and established wage norms these new efficient areas may not be able to attract the best workers. With a reset of wages caused by higher inflation, however, income for the most productive people in the most productive and competitive sectors would increase the most. This would allow the job market to more accurately indicate which sectors are efficient and growing, and guide new workers to those new jobs.
For those wanting to read more, Planet Money recently examined the economy-wide benefits and drawbacks of a 5% inflation rate.


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