September 28, 2004

Why zero inflation?

The errors made by Alan Greenspan over the past few years—failing to predict the recession in 2001, predicting deflation in 2002, muting his reservations over the Bush tax cuts—have fanned away that old aura of invincibility. Still, he has a lot of credibility with Wall Street, he knows how to set expectations, and he made a bunch of right monetary calls throughout the '90s. So when the Washington Post wonders who will fill Greenspan's shoes, we can imagine some pretty damn big shoes. Maybe too big: it seems that all of Greenspan's potential successors would continue to pursue price stability over full employment:
Fed officials of both parties are closely aligned these days in a consensus, developed over the past two decades, that the best way to foster economic growth and lower unemployment is to keep inflation very low. That buried the argument made by many economists and politicians until the late 1980s that the Fed could reduce unemployment by letting inflation creep higher.
Point of order: this isn't quite the consensus that the Post makes it out to be—after all, Alan Blinder, Vice Chairman of the Fed, has argued that a little inflation is a decent price to pay for full employment. Meanwhile, George Akerloff has shown that at zero inflation, employers have a hard time cutting real wages. Why? Well, it's easy to give an employee a 2% nominal raise during a period of 3% inflation—the worker's getting a pay-cut, but not an overly noticeable one. It's a lot harder, though, to give an employee a 1% nominal cut in a time of zero inflation—not only is the cut psychologically damaging, but many union contracts forbid nominal cuts. Akerloff projected that at zero-inflation, we'd have an unemployment rate one or two points higher than we would at 3 percent inflation.

Another thing to note is that, at very low inflation, the Fed doesn't have a whole lot of options for combating asset bubbles. Ideally it would raise rates more to head off the bubble, but it certainly doesn't want to sink into deflation. (I take it the Bank of Japan had this problem in the early '90s.) Greenspan pretty much gambled in 2000 that he didn't need to respond to steadily rising stock prices—and the results weren't pretty. Obviously, hindsight doesn't need to squint, but the problems with price stability should at least give the "consensus" some pause, shouldn't it?
-- Brad Plumer 1:18 AM || ||