Today I was browsing through the topics on iTunes U, a collection of free lectures, and stopped at macroeconomics. I downloaded a course collection on macro from Saylor University, and opened up an item of particular interest, “The Cost of Inflation.” This particular document is available publicly on the Cleveland Fed’s website, and any quotes presented here are from the Cleveland Fed document.
There isn’t much to quibble with, considering the dramatic examples that are presented such as an inflation rate that accelerates from zero to ten percent in a very short period of time. It also cites studies of incidents of hyperinflation in Europe during the 20th century.
One of the parts I find puzzling is that presents a notion of the welfare cost of inflation without defining this rather nebulous term; and statements like this one leave me scratching my head:
If optimal monetary policy implies a zero nominal interest rate, what should the inflation rate be? A relationship known as the Fisher equation tells us that the nominal interest rate is (approximately) equal to the inflation rate plus the real rate of interest. Consequently, the optimal inflation rate is the negative of the real interest rate. For example, if the real interest rate is 3 percent, then the optimal rate of inflation is –3 percent. By similar reasoning, the value of the nominal interest rate tells us how much the inflation rate exceeds its socially optimal level.
So, we should have the central bank forcing a -3 percent inflation rate during an oil price shock and expect that to be the socially optimum level? Perhaps it is socially optimum if we like lots of unemployment and laying waste to a generation of young people. It doesn’t make a lot of sense to me.
For a reality check, after the damage is done, with reasoning straight out of the minds of inflation targeting advocates, if the real interest rate is negative, then the rate of inflation should be the inverse in order to be considered socially optimum. If the real interest rate is -3 percent, then the inflation rate should be 3 percent to achieve zero nominal interest. What happens to debt obligations if it is not zero in that situation?
If this is what they really believe, then I do not understand how Bernanke and co. have gotten away with not having a zero rate of nominal interest. Where is the outrage when it is plainly obvious what it means to people with mortgages and other debt.
As the paper proceeds to discuss the deadweight cost in GDP from inflation, one is left with the impression that purchasing power is a function of supply. I would guess that it is probably the impact of monetary disequilibrium that is implied. But it is not identified as such, leaving plenty of room for misunderstanding.
To illustrate the problem with this paper, and why it appears incomplete; here is what it says about the deadweight cost from inflation (emphasis is mine; references and notations omitted):
What about more modest inflation experiences? Stanley Fischer, using money demand estimates for the United States, calculated that lowering the inflation rate from 10 percent to 0 percent would generate a welfare gain of between 0.3 and 0.8 percent of output. While this figure may seem fairly modest, when applied to U.S. GDP for 1999, it implies a deadweight loss of between $28 billion and $74 billion. The magnitude of this welfare cost is comparable to that associated with other distortionary taxes. Furthermore, this welfare gain can be achieved each and every year—it is not a once-off gain.
Thomas Cooley and Gary Hansen were among the first to try to quantitatively assess the costs of inflation in an environment like the one outlined above. Relative to an optimal inflation rate (–4 percent per annum in their model), they found that an inflation rate of 10 percent resulted in a welfare cost of 0.4 percent of income. This figure is fairly typical of the estimates other researchers have subsequently obtained.
If the cost of a 10 percent inflation rate relative to an optimal inflation rate (4 percent real interest is implied) is 0.04 percent of income, what is the cost in expected nominal income if NGDP is 15 percent below trend yoy? How does one justify a disinflation of 6 percent inclusive of headline measures if starting from ~4 percent if it necessitates an initial plunge in NGDP of 8 percent that drifts farther downward, away from trend over time? Simple math informs which is more costly to income, thus public welfare, yet nobody has held the Bernanke Fed to account for disinflation run amuck, especially when its members babble on about the costs and risks of QE.
In some respects, I wish I had never seen this paper. I would prefer an NGDP level target over this as a driving factor for the development and implementation of monetary policy. But perhaps the idea adds complexity if what one is really seeking is accountability and reform; because it isn’t particularly needed to point out how badly the Fed failed and that everyone else who should have known better has been ignoring it while the labor force atrophies to the smallest it’s been in 30 years. Even people who believe in inflation targeting should know that what has been happening with monetary policy has been very wrong. Where are they?