We Need Inflation-Tolerance, Not Inflation

People sometimes characterize me as thinking that more inflation would help the American economy. I think it might, perhaps, within limits. But what I really think is that more tolerance of inflation would help the economy, not the inflation itself. I’ve got an analogy that perhaps can help explain the difference.

Imagine you’re watching an Olympic-quality archer who’s having a very bad day. You notice that not only is his overall score much worse than he normally does, but all of his arrows are falling lower than the bullseye. You ask him about it and he tells you that his daughter’s been kidnapped, and the kidnapper says he’ll kill the girl if he shoots a single arrow above the bullseye. Now it all makes sense. The archer hasn’t lost his skill. He’s deliberately aiming too low because he has enormous aversion to shooting above the bullseye. If he lost that aversion, his score would improve.

The moral of the story isn’t that shooting too high is a good way to win an archery tournament. To win, you need to hit the bullseye—neither too high nor too low. But if you become strongly averse to shooting too high, that’s going to undermine your ability to hit the bullseye.

That’s the situation I think American monetary policy is in. It’s not that three or four percent inflation is such a wonderful goal. It’s that extreme aversion to three or four percent inflation is causing the Federal Reserve to persistently “shoot too low” in terms of aggregate demand. Ben Bernanke’s acting as if someone’s holding his daughter hostage. Specifically, the reigning dogma is that if inflation were to go from 2 percent to 3 or 4 percent that long-term expectations might become “unanchored” and drift higher and higher, undermining the “hard won gains” of the Volcker years. But there’s no empirical evidence that this is true, and no particularly strong theoretical reason to believe than the worst-case scenario if inflation tolerance goes wrong is worse that the current strategy of grinding the recession out by letting America’s long-term productive capacity collapse.