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September 12, 2017

Note to Fed: Low Inflation Is a Feature, Not a Bug


The Federal Reserve Bank is in handwringing mode again, as it frets that it can’t seem to push inflation up to its targeted 2 percent rate. But while a sub-2 percent inflation rate may be a defeat for the Fed, it’s a victory for the economy—and our pocketbooks. 

The Fed is obsessed with a fear that the U.S. might return to a period of deflation, which is marked by a general decrease in prices. The concern is that people will refrain from buying in a deflationary period, hoping prices will move even lower.  

Of course, Wal-Mart, Amazon and the Internet help people find lower prices every day!  And when they find what they believe is a good deal, they buy. 

But the deflation fear is overblown. According to the U.S. Inflation Calculator, in the 77 years since 1940 there have only been three years when the U.S. experienced negative average annual inflation rates—i.e. deflation—and the last one was 27 years ago. However, there were six years of negative annual inflation rates in the 1930s during the Great Depression. But that’s exactly what you’d expect in a depression. 

By contrast, there have been 20 years where the U.S. inflation was 5 percent or more, and six exceeding 10 percent.  

Economists used to think that inflation was the real threat to an economy, while low inflation has numerous benefits, because it: 

Protects seniors’ savings. Inflation decreases the value of each dollar, making debtors better off than savers—e.g., seniors—which is one reason why debtor governments have historically embraced higher inflation rates. 

However, low inflation also reduces or eliminates recipients Cost of Living Adjustment (COLA) increases to Social Security payments, which is bad for seniors but good for the economy. 

Keeps federal interest payments lower. Speaking of debtors, the federal government must pay interest on its $20 trillion in debt—$433 billion in 2016. Higher inflation would almost certainly mean significantly higher interest payments.  

Keeps expensive items more affordable. Low inflation keeps both prices and interest rates lower for houses, automobiles and consumers goods that people are likely to finance. 

Implies economic stability. We typically associate runaway inflation with banana republics run by despots. Low to zero inflation sends a message of economic stability.

While the economy often adjusts to higher inflation by driving up the price of everything, it can lead to an inflationary cycle that’s hard to contain (e.g., 1979-81). The Fed will likely continue its efforts to micromanage the economy in the hope of reaching a 2 percent inflation rate. But as long as it fails, the rest of us win.


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