Good inflation

PRINCETON — In response to recent concerns about resurgent inflation, US policymakers deny that there is any threat and insist that expectations are “well anchored”. Any recent price spikes, they argue, will prove temporary, arising from one-off shortages that will be resolved when life returns to normal after the pandemic. Nonetheless, market participants and investors are increasingly obsessed with the issue and pundits are rancorously divided, with some denouncing those with whom they disagree as “cockroaches”.

Such rhetoric suggests a need to step back and think about what is meant by inflation and its opposite, deflation. Not all inflations or deflations are alike. Price declines (deflation) driven by technical improvements can be good, as in the case of electrical motors or chemical dyes in the late nineteenth century, or of computers (and many other electronic consumer goods) over the past 50 years. These are not the sort of price changes that lead to Great Depression-style defaults and debt crises.

The same distinction applies to inflation. There can be “good” price increases, as in cases where markets need a signal to produce a certain response. The current surge in the price of computer chips reflects a shortage of supply, which in turn is curtailing production of automobiles, refrigerators and other products that rely on these components. But “Chipageddon” is not the end of the world. Rather, it is giving chip producers a clear signal to ramp up production and increase supply. Here, price increases are serving a useful role and we can expect that chip prices will come down in the future.

Or consider a scenario where a different market response is required. Today’s rapid recovery has increased the demand for freight transportation, pushing up fuel and energy prices. Moreover, a shortage of truck drivers and a ransomware attack on a major East Coast pipeline have left gas stations empty. But these scarcities are the result of temporary glitches. They do not augur a repeat of the 1970s oil shock.

What higher gasoline prices will do is signal to consumers that it pays to reduce one’s fuel consumption and dependence on fossil fuels. That message aligns nicely with a wider recognition that the economy urgently needs to shift away from carbon-intensive energy sources. Again, we should allow prices to perform their proper function of guiding consumers’ behaviour and future consumption plans.

These contemporary phenomena do not represent the kind of inflation that would justify pumping the brakes on the recovery. Higher chip and fuel prices simply reflect what producers and consumers need to do. As an impressively efficient planning instrument, the price signal is not an indicator that should be suppressed, just as febrile patients should not be told to put their thermometers in the refrigerator. The high temperature reading provides necessary information for recovering one’s health.

Historically, major accelerations of globalisation have often been accompanied by inflationary surges, each of which has led politicians and consumers to cast around for culprits. In the 1850s-60s, rising prices were interpreted as a response to gold discoveries or financial innovation following the development of new types of banking. In the 1970s, US monetary policy bore much of the blame, though some also pointed to financial innovation (a surge of international bank lending) and the role of producer-country cartels.

But the fact is that in both cases, price effects helped to trigger behavioural changes that eventually brought efficiency gains and lower prices (“good deflation”). Hence, it might be helpful to think of contemporary price increases as examples of “good inflation”, insofar as they represent the first step in a useful and beneficial process.

Such a change in mindset would require a departure from the consensus of the 1990s and 2000s, when inflation targeting became central banks’ key weapon in the quest for price stability. Around the world, governments and central banks reached a common view that a 2 per cent — or perhaps 2.5 per cent — rate of inflation (based on an index of consumer prices) was desirable. Accordingly, they started to worry whenever the rate moved even a few decimal points below (or above) that line, usually on the basis of past horror stories about bad deflation (the Great Depression) or bad inflation (as in the aftermath of the twentieth century’s world wars).

This monetary-policy consensus was appropriate for a stable world in which there had been no radical shocks for many years. One of its key advocates, then-Bank of England Governor Mervyn King, described the era well when he coined the acronym NICE: Non-inflationary continuing expansion.

But we are no longer in a NICE world. Today’s world demands dramatic changes in behaviour, and the price mechanism is the most powerful instrument we have for communicating how companies and individuals should respond. The pandemic has dramatically accelerated the adoption of information communication technologies, creating a need for greater investments to facilitate new global linkages and to ensure efficiency and equitableness. It has also demonstrated how important collective action is in overcoming problems that are genuinely global — namely, climate change.

When radical, society-wide shifts in consumption patterns are both expected and desired, it is no longer appropriate to base policy responses on one simple price index. We need to disaggregate prices in a way that aligns with our shared principles and priorities. For example, we should consider excluding the prices of anti-social or otherwise undesirable goods, such as fossil fuels and tobacco products, from the calculation. And we should think of other metrics to help guide us in measuring how efficiently societies and countries are responding to today’s defining challenges.

Harold James is professor of History and International Affairs at Princeton University and a senior fellow at the Centre for International Governance Innovation. A specialist on German economic history and on globalisation, he is a co-author of “The Euro and The Battle of Ideas”, and the author of “The Creation and Destruction of Value: The Globalisation Cycle, Krupp: A History of the Legendary German Firm”, “Making the European Monetary Union” and the forthcoming “The War of Words”. ©Project Syndicate, 2021. 

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