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Why you should stop worrying and learn to love inflation

Published: Wednesday, Sept. 18 2013 9:35 a.m. MDT

Why a little inflation is good

Sumner says a little bit of inflation "greases the wheels" of the marketplace by making it easier to adjust people's real wages (the actually buying power of the salary) without having to adjust their nominal wage (the dollar amount).

For example, a worker may get a 3 percent raise in her wages, but inflation may have made the value of those dollars worth 4 percent less — leaving her with a 1 percent drop in real wages. It seemed like a raise, but it wasn't.

"If there was no inflation in the economy and you gave people a 3 percent pay cut, they would probably be outraged," Sumner says. "But if you have 8 percent inflation and they got a 5 percent raise that would be the exact same thing. They got a 3 percent pay cut in real terms. But they are not quite as outraged because they think they are getting more money. They don't blame the firm, they blame the economy. They think, 'Well, at least the firm gave us a 5 percent raise.'"

Sumner calls this a money illusion.

Why high inflation is bad

"High inflation really hurts savings and investment and kind of distorts the economy," Sumner says. "The higher the rate of inflation the more you tend to rip off people who are thrifty and save and invest. This is partly because you are taxing them on gains that are actually inflated — they are not real gains."

For example, in the 1970s high inflation was hard on savers.

"High inflation is bad, because it punishes savings and investors too much," Sumner says.

Affecting the economy

In normal times, the Fed tries to help the economy by taking action to reduce the inflation rate to 2 percent.

"The Fed has been doing this for a long time, but it was never controversial," Sumner says. "The reason it was never controversial was that they were very rarely ever in the position of trying to raise the inflation rate. They were usually trying to lower it down to the 2 percent."

"Back in 2010 when Ben Bernanke, chairman of the Federal Reserve, announced that he was trying to raise inflation, he ran into a real buzzsaw of criticism," Sumner says, "because is sounded bad to the average person."

Sumner says the average person thought raising inflation would reduce their standard of living. Sumner says the opposite was true. Because we were in a recession, a higher inflation can only be generated by the Federal Reserve pumping up what's called aggregate demand in the economy — trying to create a boom condition in the economy. "That would have put more people back to work," Sumner says. "Americans would have been better off. But because the Fed ran into so much criticism, they backed off on the policy."

The result is we still have less than 2 percent inflation today.

Printing money

The normal policy tool used by the Federal Reserve is lowering and raising interest rates for banks. The banks then, in turn, would lend out money at higher interest rates. When the Federal Reserve's interest rates fell to zero, they couldn't lower the rates any more. This led to another way of affecting the economy called quantitative easing.

Quantitative easing is a way of affecting the money supply by printing more dollars and, by buying bonds with that money, depositing that money in banks. This gives the banks more money to lend out. The more money lent out, the greater the money supply and the greater the inflation.

"In normal times doing this sort of increase in the quantity of the money supply would be very inflationary, Sumner says. "It would even be hyper inflationary," he says. "That is absolutely correct."

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