Is Inflation Necessary?

• Inflation is beneficial when it counteracts the negative impacts of deflation, which are often more damaging to an economy.
• Consumers spend today because they expect prices to rise in the future, encouraging economic growth.
• Managing future inflation expectations is an important part of maintaining a stable inflation rate.

Is inflation actually required?

Many economists, businesspeople, and politicians believe that mild inflation is necessary to stimulate consumer spending, presuming that higher levels of expenditure are necessary for economic progress.

Why isn’t there any inflation?

Regardless of whether the Mack bill succeeds, the Fed will have to assess if it still intends to pursue lower inflation. We evaluated the costs of maintaining a zero inflation rate and found that, contrary to prior research, the costs of maintaining a zero inflation rate are likely to be considerable and permanent: a continued loss of 1 to 3% of GDP each year, with increased unemployment rates as a result. As a result, achieving zero inflation would impose significant actual costs on the American economy.

Firms are hesitant to slash salaries, which is why zero inflation imposes such high costs for the economy. Some businesses and industries perform better than others in both good and bad times. To account for these disparities in economic fortunes, wages must be adjusted. Relative salaries can easily adapt in times of mild inflation and productivity development. Unlucky businesses may be able to boost wages by less than the national average, while fortunate businesses may be able to raise wages by more than the national average. However, if productivity growth is low (as it has been in the United States since the early 1970s) and there is no inflation, firms that need to reduce their relative wages can only do so by reducing their employees’ money compensation. They maintain relative salaries too high and employment too low because they don’t want to do this. The effects on the economy as a whole are bigger than the employment consequences of the impacted firms due to spillovers.

What role does inflation play in the economy?

Inflation is and has been a contentious topic in economics. Even the term “inflation” has diverse connotations depending on the situation. Many economists, businesspeople, and politicians believe that mild inflation is necessary to stimulate consumer spending, presuming that higher levels of expenditure are necessary for economic progress.

How Can Inflation Be Good For The Economy?

The Federal Reserve usually sets an annual rate of inflation for the United States, believing that a gradually rising price level makes businesses successful and stops customers from waiting for lower costs before buying. In fact, some people argue that the primary purpose of inflation is to avert deflation.

Others, on the other hand, feel that inflation is little, if not a net negative on the economy. Rising costs make saving more difficult, forcing people to pursue riskier investing techniques in order to grow or keep their wealth. Some argue that inflation enriches some businesses or individuals while hurting the majority.

The Federal Reserve aims for 2% annual inflation, thinking that gradual price rises help businesses stay profitable.

Understanding Inflation

The term “inflation” is frequently used to characterize the economic impact of rising oil or food prices. If the price of oil rises from $75 to $100 per barrel, for example, input prices for firms would rise, as will transportation expenses for everyone. As a result, many other prices may rise as well.

Most economists, however, believe that the actual meaning of inflation is slightly different. Inflation is a result of the supply and demand for money, which means that generating more dollars reduces the value of each dollar, causing the overall price level to rise.

Key Takeaways

• Inflation, according to economists, occurs when the supply of money exceeds the demand for it.
• When inflation helps to raise consumer demand and consumption, which drives economic growth, it is considered as a positive.
• Some people believe inflation is necessary to prevent deflation, while others say it is a drag on the economy.
• Some inflation, according to John Maynard Keynes, helps to avoid the Paradox of Thrift, or postponed consumption.

When Inflation Is Good

When the economy isn’t operating at full capacity, which means there’s unsold labor or resources, inflation can theoretically assist boost output. More money means higher spending, which corresponds to more aggregated demand. As a result of increased demand, more production is required to supply that need.

To avoid the Paradox of Thrift, British economist John Maynard Keynes argued that some inflation was required. According to this theory, if consumer prices are allowed to decline steadily as a result of the country’s increased productivity, consumers learn to postpone purchases in order to get a better deal. This paradox has the net effect of lowering aggregate demand, resulting in lower production, layoffs, and a faltering economy.

Inflation also helps borrowers by allowing them to repay their loans with less valuable money than they borrowed. This fosters borrowing and lending, which boosts expenditure across the board. The fact that the United States is the world’s greatest debtor, and inflation serves to ease the shock of its vast debt, is perhaps most crucial to the Federal Reserve.

Economists used to believe that inflation and unemployment had an inverse connection, and that rising unemployment could be combated by increasing inflation. The renowned Phillips curve defined this relationship. When the United States faced stagflation in the 1970s, the Phillips curve was severely discredited.

Is inflation beneficial to stocks?

Consumers, stocks, and the economy may all suffer as a result of rising inflation. When inflation is high, value stocks perform better, and when inflation is low, growth stocks perform better. When inflation is high, stocks become more volatile.

What is the extent of inflation?

Year-on-year inflation rates have reached their greatest levels in over three decades as the global economy recovers from the COVID-19 epidemic. Is this higher inflation just a blip on the radar, or is it here to stay? Patricia Sanchez Juanino, Corrado Macchiarelli, and Barry Naisbitt explore US inflation possibilities for the next 18 months to answer these questions. They believe that inflation will peak at 5% in the coming months and then remain close to 4% in the near term: this may happen if, for example, inflation expectations continue to rise.

The 12-month CPI inflation rate in the United States reached its highest level since 1990 in October 2021, at 6.2 percent year-on-year. Pent-up demand and rising energy prices have been primary drivers of the increase, but supply chain constraints and spikes in other commodity prices have also played a role. A crucial policy question is whether the current rise in US inflation is only temporary, as it was in 2008, or if it signals the start of a longer era of inflation above the 2% objective, like it did in the 1970s and early 1980s.

The Federal Reserve has revised up its annual inflation predictions for both this year and next year as the year has progressed. The September median prediction for year-on-year PCE (household consumption) inflation in the fourth quarter increased to 4.2 percent this year and 2.2 percent next year. Both forecasts are higher than those issued in March: 2.4 percent in 2021 and 2% in 2022. Despite the fact that predictions have risen, Federal Reserve policymakers still expect inflation to decline considerably next year. The Federal Open Markets Committee (the group that decides on the right monetary policy stance) stated in November that it will cut its monthly purchases of Treasury securities and mortgage-backed securities, a policy known as tapering. However, it continued to emphasize that the spike in inflation, as reflected in its inflation estimates, was primarily transitory.

While we anticipate a reduction in inflationary pressure, we are concerned that the reduction will be insufficient. Annual US PCE inflation would grow from 1.2 percent in the fourth quarter of last year to 5.1 percent this year, then decline to 2.3 percent in the fourth quarter of 2022, according to the National Institute’s Autumn 2021 Global Economic Outlook. However, we believe that the risks are skewed to the upside, and that if they materialize, the Federal Reserve will be forced to tighten monetary policy sooner than it appears to be planning.

Inflation scenarios for 2022-23

To demonstrate the dangers, we employ Huw Dixon’s technique from Cardiff University, which allows us to make stylized assumptions about future monthly price fluctuations in order to generate various annual inflation routes over the next 18 months. Three scenarios are examined (rather than forecasts).

In the best-case scenario, monthly inflation reduces steadily until it reaches its average level for the five years prior to the pandemic in June of the following year, and then stays there. After that, the monthly price changes are converted into year-over-year inflation. On this measure, annual PCE inflation would decline to 2.1 percent in the fourth quarter of next year, roughly in line with the Federal Reserve’s consensus forecast.

We look at two other scenarios that are much less reassuring. We assume that the extent of monthly price increases decreases, but not as quickly or as far as before the pandemic, so that it reaches twice the pre-pandemic period average in June. In this instance, annual PCE inflation in the fourth quarter of next year would be 3.2 percent.

Finally, if monthly PCE inflation stays at its current level (0.3 percent) for the rest of the year, annual inflation in the fourth quarter of next year will be 3.9 percent. Figure 1 depicts the year-on-year inflation projected lines for several scenarios.

Figure 1: Year-over-year PCE inflation projections based on stylized monthly assumptions (percent)

The most intriguing aspect of these scenarios is that they all hint to annual inflation being near 5% in the next months. Figure 1 shows that, despite monthly inflation returning to the 2015-2019 average by next June, year-on-year inflation continues to rise over the following few months, reaching 5%, as lower monthly rises in 2020 are replaced by greater monthly increases this year. In the best-case scenario, annual inflation returns to 2% by the end of next year. If monthly inflation stays at 0.3 percent, year-over-year inflation will remain persistently close to 4%.

These are simply projections based on stylized assumptions, not forecasts or a deep examination of the underlying reasons influencing recent and future monthly price fluctuations. They are broadly consistent with the idea that annual inflation risks will remain strong through 2022, even if recent price hikes owing to supply chain disconnections fade away over time. If policies do not prevent inflation expectations from rising, the situation may worsen.

With its new mandate and a strong focus on maximum employment, the Federal Reserve expects a temporary (or, in today’s lingo, transitory) overshoot of inflation above its target, especially when it follows a long period of undershooting. If inflation expectations become skewed and wage-push inflation forces increase, a temporary overshoot could turn into a long-term one.

Higher inflation may be here to stay

According to our forecasts, the current rate of inflation could return to its target rate by the end of 2022. However, it appears that inflation will continue to exceed the objective for some years. If inflation reaches 5%, the Federal Reserve will need to significantly up its policy messaging, arguing that the spike is just temporary and convincing families, businesses, and financial markets that monthly inflation will soon revert to lower levels. If the current supply-chain disruption and global energy price increases end, its arguments will be strengthened.

The Federal Reserve has yet to clarify the timeframe of ending quantitative easing, reversing it, and subsequently raising policy interest rates. For example, an unexpected policy reversal to protect central bank credibility could cause a quick financial market slump and public sector balance sheet imbalances. How central banks respond to increasing inflation, through a mix of terminating quantitative easing and raising policy rates, will determine bond prices.

Inflation expectations are rising, and the Federal Reserve needs to create contingency plans for its actions if a 5% inflation rate appears to be embedded. If it lifts its inflation predictions again after its December meeting, as we expect, such contingency measures may be required sooner rather than later. Given the uncertainty about the duration of higher inflation, wages, and an employment rate that remains below pre-pandemic levels, we believe the Federal Reserve will be cautious in tightening policy, especially because it will have to choose between stabilizing below-target employment and stabilizing above-target inflation. Moving too far, too fast, risks squandering the best chance it has to avoid near-deflationary traps with interest rates at their lowest levels. They are likely to pay the price if it is a time of significantly above-target inflation.

• “US inflation peaking soon?” in National Institute of Economic and Social Research (Box A), Global Economic Outlook, Series B., No. 4, Autumn, pp. 24-30, is the basis for this article. ‘Global Economic Outlook’, Series B, No. 4, Autumn, NIESR (2021).

Is it feasible to have zero inflation?

Inflation has a variety of economic costs – uncertainty, decreased investment, and redistribution of wealth from savers to borrowers but, despite these costs, is zero inflation desirable?

Inflation is frequently targeted at roughly 2% by governments. (The UK CPI objective is 2% +/-.) There are good reasons to aim for 2% inflation rather than 0% inflation. The idea is that achieving 0% inflation will need slower economic development and result in deflationary problems (falling prices)

Potential problems of deflation/low inflation

• Debt’s true value is increasing. With low inflation, people find it more difficult to repay their debts than they anticipated they must spend a bigger percentage of their income on debt repayments, leaving less money for other purposes.
• Real interest rates are rising. Whether we like it or not, falling inflation raises real interest rates. Rising real interest rates make borrowing and investing less appealing, encouraging people to save. If the economy is in a slump, a rise in real interest rates could make monetary policy less effective at promoting growth.
• Purchase at a later date. Falling prices may motivate customers to put off purchasing pricey luxury products for a year, believing that prices would be lower.
• Inflationary pressures are a sign of slowing economy. Inflation would normally be moderate during a normal period of economic expansion (2 percent ). If inflation has dropped to 0%, it indicates that there is strong price pressure to promote spending and that the recovery is weak.
• Prices and wages are more difficult to modify. When inflation reaches 2 percent, relative prices and salaries are easier to adapt because firms can freeze pay and prices – effectively a 2 percent drop in real terms. However, if inflation is zero, a company would have to decrease nominal pay by 2% – this is far more difficult psychologically because people oppose wage cuts more than they accept a nominal freeze. If businesses are unable to adjust wages, real wage unemployment may result.

Evaluation

There are several reasons for the absence of inflation. The drop in UK inflation in 2015 was attributed to temporary short-term factors such as lower oil and gasoline prices. These transient circumstances are unlikely to persist and have been reversed. The focus should be on underlying inflationary pressures core inflation, which includes volatile food and oil costs. Other inflation gauges, such as the RPI, were 1 percent (even though RPI is not the same as core inflation.) In that situation, inflation fell during a period of modest economic recovery. Although inflation has decreased, the economy has not entered a state of recession. In fact, the exact reverse is true.

Inflation was near to zero in several southern Eurozone economies from 2012 to 2015, although this was due to decreased demand, austerity, and attempts to re-establish competitiveness, which resulted in lower rates of economic growth and more unemployment.

It all depends on what kind of deflation you’re talking about. Real incomes could be boosted by falling prices. One of the most common concerns about deflation is that it reduces consumer spending. However, as the price of basic needs such as gasoline and food falls, consumers’ discretionary income/spending power rises, potentially leading to increased expenditure in the near term.

Wages that are realistic. Falling real earnings have been a trend of recent years, with inflation outpacing nominal wage growth. Because nominal wage growth is still low, the decrease in inflation will make people feel better about themselves and may promote spending. It is critical for economic growth to stop the decline in real wages.

Expectations for the future. Some economists believe that the decline in UK inflation is mostly due to temporary factors, while others are concerned that the ultra-low inflation may feed into persistently low inflation expectations, resulting in zero wage growth and sustained deflationary forces. This is the main source of anxiety about a 0% inflation rate.

Do we have a plan to combat deflation? There is a belief that we will be able to overcome any deflation or disinflation. However, Japan’s history demonstrates that once deflation has set in, it can be quite difficult to reverse. Reducing inflation above target is very simple; combating deflation, on the other hand, is more of a mystery.

Finances of the government In the short term, the decrease in inflation is beneficial to the government. Index-linked benefits will rise at a slower rate than predicted, reducing the UK government’s benefit bill. This might save the government a significant amount of money, reducing the deficit and freeing up funds for pre-election tax cuts.

Low inflation, on the other hand, may result in decreased government tax collections. For example, the VAT (percentage) on items will not rise as much as anticipated. Low wage growth will also reduce tax revenue.

Consumers are frequently pleased when there is little inflation. They will benefit from lower pricing and the feeling of having more money to spend. This ‘feel good’ component may stimulate increased confidence, which could lead to increased investment, spending, and growth. Low inflation could be enabling in disguise in the current context.

However, there is a real risk that if we get stuck in a time of ultra-low inflation/deflation, all of the difficulties associated with deflation would become more visible and begin to stifle regular economic growth.

Should we strive towards inflation zero?

The purpose of central banks, such as the Federal Reserve, is to promote economic growth and social welfare. The government has given the Federal Reserve, like central banks in many other nations, more defined objectives to accomplish, especially those related to inflation.

What is the Federal Reserve’s “dual mandate”?

Congress has specifically charged the Federal Reserve with achieving goals set forth in the Federal Reserve Act of 1913. The aims of maximum employment, stable prices, and moderate long-term interest rates were clarified in 1977 by an amendment to the Federal Reserve Act, which mandated the Fed “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The “dual mandate” refers to the goals of maximum employment and stable prices.

Does the Federal Reserve have a specific target for inflation?

The Federal Open Market Committee (FOMC), the organization of the Federal Reserve that controls national monetary policy, originally released its “Statement on Longer-Run Goals and Monetary Policy Strategy” in January 2012. The FOMC stated in the statement that “inflation at a rate of 2%, as measured by the annual change in the price index for personal consumption expenditures, is most compatible with the Federal Reserve’s statutory mandate over the longer term.” As a result, the FOMC’s PCE inflation target of 2% was born. Inflation targets are set by a number of central banks around the world, with many of them aiming for a rate of around 2%. Inflation rates around these levels are often associated with good economic performance: a higher rate could prevent the public from making accurate longer-term economic and financial decisions, as well as entail a variety of costs as described above, whereas a lower rate could make it more difficult to prevent the economy from deflation if economic conditions deteriorate.

The FOMC’s emphasis on clear communication and transparency includes the release of a statement on longer-term aims. The FOMC confirmed the statement every year until 2020. The FOMC issued a revised statement in August 2020, describing a new approach to achieve its inflation and employment goals. The FOMC continues to define price stability as 2 percent inflation over the long run. The FOMC stated that in order to attain this longer-term goal and promote maximum employment, it would now attempt to generate inflation that averages 2% over time. In practice, this means that if inflation has been consistently below 2%, the FOMC will most likely strive to achieve inflation moderately over the 2% target for a period of time in order to bring the average back to 2%. “Flexible average inflation targeting,” or FAIT, is the name given to this method.

Why doesn’t the Federal Reserve set an inflation target of 0 percent?

Despite the fact that inflation has a range of societal consequences, most central banks, including the Federal Reserve, do not strive for zero inflation. Economists usually concentrate on two advantages of having a tiny but favorable amount of inflation in an economy. The first advantage of low, positive inflation is that it protects the economy from deflation, which has just as many, if not more, difficulties as inflation. The second advantage of a small amount of inflation is that it may increase labor market efficiency by minimizing the need for businesses to reduce workers’ nominal compensation when times are tough. This is what it means when a low rate of inflation “lubricates the gears” of the labor market by allowing for actual pay reduction.

Does the Fed focus on underlying inflation because it doesn’t care about certain price changes?

Monetary officials generally spend a lot of time talking about underlying inflation measures, which might be misinterpreted as a lack of understanding or worry about particular price fluctuations, such as those in food or energy. However, policymakers are worried about any price fluctuations and consider a variety of factors when considering what steps to take to achieve their goals.

It is critical for Federal Reserve policymakers to understand that underlying inflation metrics serve as a guide for policymaking rather than as an end goal. One of monetary policy’s goals is to achieve 2% overall inflation, as assessed by the PCE price index, which includes food and energy. However, in order to adopt the appropriate policy steps to reach this goal, policymakers must first assess which price changes are likely to be short-lived and which are likely to stay. Underlying inflation measures give policymakers insight into which swings in aggregate inflation are likely to be transitory, allowing them to take the optimal steps to achieve their objectives.

Is there a world without inflation?

We’ve covered a lot of ground on the many notions of inflation in past posts. We have a thorough understanding of how things work. When it comes to inflation, though, the optimal way for things to be is also critical. The only way to establish an acceptable agreement is to have a clear aim in mind. When setting inflation goals, one frequently encounters the question of whether a world without inflation is even possible.

The remainder of this article will examine the data at hand in order to provide an answer to the aforementioned query.

Stable Monetary Systems in the Past:

Contrary to popular thought, a world without inflation is not a far-fetched dream. Our modern media has misled us into believing that inflation can only be regulated, not eliminated, which is untrue. A tertiary examination of monetary history reveals the truth. The globe had never seen such out-of-control inflation in the centuries before the current monetary system. The gold standard provided a stable foundation on which to create a monetary system, and as a result, the value of major currencies such as the dollar and the pound sterling varied very little throughout this time. As a result, in order to return to this ideal world without inflation, we must first understand what has changed since then.

• The most significant shift since World War II is that the entire world is no longer on the gold standard. Every country in the world now has a fiat money system, in which governments can create money using the power they have. This is a once-in-a-lifetime event that has never happened before. This is critical because fiat currency systems allow governments to raise their money supply without restriction over night! Through the ages, this system has been prone to corruption. Government involvement with the monetary system is reduced in a world without inflation.
• While it may appear that the government is working in the best interests of the broader public, this is not the case. However, empirical evidence contradicts this. Please see the Austrian school of economics’ book “What has the government done with our money?” for further information.
• Fractional Reserve Banking: The eradication of the fractional reserve banking system is the second most critical development towards an inflation-free planet. Fractional reserve banking is a method of lending out money that a bank does not have! These banks, like governments, produce money when they lend it! As a result, fractional reserve banking causes dilution of the money supply, which, as we all know, is the underlying cause of inflation.

Given the current geopolitical situation, the above suggested steps are radical and nearly impossible to implement. However, any era of sustained prosperity has never been feasible with either fiat currency or fractional reserve banks present, according to economic history.

Money Supply Must Grow At The Same Rate As Output:

For prices to remain steady, the growth of the world’s physical output must be matched by the growth of the world’s money supply. There will be no inflation if global GDP rises by 5% and the money supply grows by 5% during the same time period.

Because the stock of new gold discovered and supplied to the money supply almost rises and falls at the same rate as the economy, the gold standard was an era without uncontrolled inflation. As a result, it, like paper currency, cannot be easily debased or printed in large quantities overnight to cause hyperinflation. In fact, under the gold standard, hyperinflation is a weird and inconceivable scenario.

Changing Expectations Regarding Salaries:

Another essential aspect to note is that our expectations for future pay growth or fall are conditioned by the fiat money system’s requirements. Take, for example, the gold standard. Given that the entire supply of money only grows by 3% to 5%, a 10% pay increase for everyone would be unattainable. However, because prices remain consistent or even fall in some circumstances, money retains its purchasing power, allowing spenders to enjoy a higher standard of living. It’s understandable if no wage increase has occurred in years. Under the gold standard, however, this was always the case.

Changing Expectations Regarding Prices:

The good news is that costs will not rise. In fact, in an inflation-free environment, prices tend to fall. Productivity rises as a result of technological advancements. Because it is now cheaper to make, productivity leads to a decrease in pricing. Prices are falling, while earnings are constant, resulting in a higher standard of living.

Why can’t we simply print more cash?

To begin with, the federal government does not generate money; the Federal Reserve, the nation’s central bank, is in charge of that.

The Federal Reserve attempts to affect the money supply in the economy in order to encourage noninflationary growth. Printing money to pay off the debt would exacerbate inflation unless economic activity increased in proportion to the amount of money issued. This would be “too much money chasing too few goods,” as the adage goes.

Where should I place my money to account for inflation?

“While cash isn’t a growth asset, it will typically stay up with inflation in nominal terms if inflation is accompanied by rising short-term interest rates,” she continues.

CFP and founder of Dare to Dream Financial Planning Anna N’Jie-Konte agrees. With the epidemic demonstrating how volatile the economy can be, N’Jie-Konte advises maintaining some money in a high-yield savings account, money market account, or CD at all times.

“Having too much wealth is an underappreciated risk to one’s financial well-being,” she adds. N’Jie-Konte advises single-income households to lay up six to nine months of cash, and two-income households to set aside six months of cash.

Lassus recommends that you keep your short-term CDs until we have a better idea of what longer-term inflation might look like.