The case for higher inflation

[Brainster]

Modest inflation (say in the 3-5% per annum range) is probably a net positive to society as a whole. It encourages purchases of assets like real estate and also encourages risk-taking in investments. On the other hand, it is far from a panacea. For example, interest rates incorporate expected inflation rates. Classical interest rate theory says that interest rates have three components: the "real interest rate" that investors want to make on their money, the expected inflation rate, and the risk rate. US Treasuries have historically been considered as reflecting the first two components (as Treasuries are considered the lowest risk investment possible). So every increase of 1% in the expected inflation rate should result in a 1% increase in overall interest rates. With the US debt (not the deficit) increasing rapidly, this would result in a significant additional cost to the federal government.

Inflation is also harmful to those living on a fixed income, which with pension funds increasingly switching to defined contribution rather than defined benefits could hurt those people significantly. In addition, maintaining moderate inflation has proven difficult in the past; see the 1979-1982 era when the Fed raised interest rates during a very difficult and painful recession precisely because inflation was out of control. Inflation can lead to hyper-inflation, which is very bad for the economy, as it discourages savings and investment in favor of consumption.

Krugman is, of course, an idiot, and I do not apologize for noting this to those who would raise the argumentum ad Nobelum fallacy. He's concerned about his famous "double dip" recession, the same way he was in 2001-2002 (read his columns back then). Of course, the only real double dip recession in my lifetime came in 1979-1981, and was caused by the inflation he urges upon us now.

 

[drkitten]

Krugman is, of course, an idiot,

I like it when partisan hacks choose this particular method to announce they have neither credibility nor economic knowledge.

and I do not apologize for noting this to those who would raise the argumentum ad Nobelum fallacy.

Of course not. How about the "argumentam ad facultymemberius ad optimus departmentus economicus" fallacy?

Which economics faculty granted you tenure?

 

[Francesca R]

Modest inflation [ . . . ] encourages purchases of assets like real estate and also encourages risk-taking in investments.

[ . . . ] interest rates incorporate expected inflation rates.

But so do claims on real cash flows, which is what investments are (including real estate). Since inflation is incorporated into the cost of capital and the return on capital, it can't logically be said to encourage investment, unless the investment itself is better protected from expected inflation than the source of funding. Deflation does discourage investment (and consumption) however.

Classical interest rate theory says that interest rates have three components: the "real interest rate" that investors want to make on their money, the expected inflation rate, and the risk rate. US Treasuries have historically been considered as reflecting the first two components (as Treasuries are considered the lowest risk investment possible).

Government bills (very short maturity) have the lowest risk and effectively zero premium above the first two components. Long dated bonds--even if they are sovereign issued--have a risk premium which is the price of compensation for the volatility of the very short term risk-free rate, annd is captured by the duration and convexity of the bond.

So every increase of 1% in the expected inflation rate should result in a 1% increase in overall interest rates. With the US debt (not the deficit) increasing rapidly, this would result in a significant additional cost to the federal government.

Does not follow; the inflation premium in the interest rate is (if it is correct) exactly offset by the reduction in the real value of the stock of debt.

Inflation is also harmful to those living on a fixed income, which with pension funds increasingly switching to defined contribution rather than defined benefits could hurt those people significantly.

Correct if their income is not protected against inflation. State entitlements normally are. And if actual inflation broadly equals expected inflation, then the returns from and the value of real assets (equities, real estate, bonds, bills, money markets, . . . ) held in a DC plan should be protected from it as well.

In addition, maintaining moderate inflation has proven difficult in the past; see the 1979-1982 era when the Fed raised interest rates during a very difficult and painful recession precisely because inflation was out of control. Inflation can lead to hyper-inflation, which is very bad for the economy, as it discourages savings and investment in favor of consumption.

Correct, though monetary authorities have had considerable success in the last two decades. But more importantly IMO, escaping from deflation is a good deal more difficult even (see "liquidity trap"), and this is the principal reason why moderate positive inflation is the anchor of monetary policy in most places rather than zero inflation.

 

[Brainster]

But so do claims on real cash flows, which is what investments are (including real estate). Since inflation is incorporated into the cost of capital and the return on capital, it can't logically be said to encourage investment, unless the investment itself is better protected from expected inflation than the source of funding. Deflation does discourage investment (and consumption) however.

Inflation encourages investment relative to (say) stuffing the money under a mattress. I certainly agree that deflation is a very bad thing.

Government bills (very short maturity) have the lowest risk and effectively zero premium above the first two components. Long dated bonds--even if they are sovereign issued--have a risk premium which is the price of compensation for the volatility of the very short term risk-free rate, annd is captured by the duration and convexity of the bond.

No disagreement here. However, note that historically, even over the last 27 years or so of relatively controlled inflation, there was a premium for longer-term debt. That is, the 10-year Treasury typically yielded more than the 5-year Treasury. There is no solid reason for this, assuming that the market anticipates fairly level inflation. It is my belief that this represents an additional risk premium for increased inflation in the future.

Does not follow; the inflation premium in the interest rate is (if it is correct) exactly offset by the reduction in the real value of the stock of debt.

But given the historical risk premium on the 10-year versus the 5-year Treasuries, there is an indication that the market prices an addition risk of higher inflation into the longer maturities. Presumably this premium would increase if inflation grew beyond the general 3% that has applied for the last quarter-century or so.

Correct if their income is not protected against inflation. State entitlements normally are. And if actual inflation broadly equals expected inflation, then the returns from and the value of real assets (equities, real estate, bonds, bills, money markets, . . . ) held in a DC plan should be protected from it as well.

But of course state entitlements are already under pressure from budget constraints. And only some investments are protected from inflation, and even then only part of the time. Housing values, for example, have certainly not kept pace with inflation for the last 5 years (although they did very well for the five years before that).

Correct, though monetary authorities have had considerable success in the last two decades. But more importantly IMO, escaping from deflation is a good deal more difficult even (see "liquidity trap"), and this is the principal reason why moderate positive inflation is the anchor of monetary policy in most places rather than zero inflation.

Agreed. Again, I'm not a proponent of deflation by any means.

 

[drkitten]

No disagreement here. However, note that historically, even over the last 27 years or so of relatively controlled inflation, there was a premium for longer-term debt. That is, the 10-year Treasury typically yielded more than the 5-year Treasury. There is no solid reason for this, assuming that the market anticipates fairly level inflation.

Well, of course. If you make false assumptions, you end up with gibberish.

The market does not "anticipate" fairly level inflation; that's certainly a goal but it's hardly a reasonable expectation. Since there's modest amount of uncertainty in inflation levels, there's a risk premium merely for uncertain inflation.

Especially since the best investment mix depends somewhat on inflation, if you lock your money away for too long in a specific investment mix, you'll create opportunity losses for yourself if inflation is too high or too low. (For example, real estate and commodities tend to be poor investments in times of low inflation, bonds in times of high inflation.) The demand (and therefore yield) for Treasuries therefore depends not only on how much inflation is expected, but also how stable it's expected to be (and therefore how long/reliable a planning horizon you have).

 

[Brainster]

Well, of course. If you make false assumptions, you end up with gibberish.

The market does not "anticipate" fairly level inflation; that's certainly a goal but it's hardly a reasonable expectation. Since there's modest amount of uncertainty in inflation levels, there's a risk premium merely for uncertain inflation.

Especially since the best investment mix depends somewhat on inflation, if you lock your money away for too long in a specific investment mix, you'll create opportunity losses for yourself if inflation is too high or too low. (For example, real estate and commodities tend to be poor investments in times of low inflation, bonds in times of high inflation.) The demand (and therefore yield) for Treasuries therefore depends not only on how much inflation is expected, but also how stable it's expected to be (and therefore how long/reliable a planning horizon you have).

Do you really think we disagree about anything you've written in this post?

 

[JJM 777]

It's just or unjust depending on your philosophy.

I am not sure that gross hereditary inequality looks "just" through any eye-glasses, unless we redefine the meaning of "just". Some philosophies tolerate or promote injustice more than some others.

So the Hindus teach a hereditary caste system. White Christians used to teach hereditary slavery of Afro-Americans. If someone says that it is "just", I think we have immediate need for a new word that means what "just" used to mean a moment before this. Then the person uses this new word for what it was not meant to mean, and then we need another word as the previous word lost its original meaning, and so on...

 

[Francesca R]

I am not sure that gross hereditary inequality looks "just" through any eye-glasses, unless we redefine the meaning of "just".

Then you're uninformed. This goes back to John Locke's "justice in acquisition" and "justice in transfer" theories from this text. (Chapter V page 144) (The date is 1690)

Some philosophies tolerate or promote injustice more than some others.

You don't have to agree with a philosophy to recognise its existence. Trying to deny one opposed to your own would just make you look ideologically blind to moral inquiry. If that was the case then this discussion will not go far.

 

[Francesca R]

Inflation encourages investment relative to (say) stuffing the money under a mattress.

Agreed if that's what you mean.

No disagreement here. However, note that historically, even over the last 27 years or so of relatively controlled inflation, there was a premium for longer-term debt. That is, the 10-year Treasury typically yielded more than the 5-year Treasury

That's the same as what I said. The duration of the 10 year is longer. This is why a "normal" yield curve is positively sloped.

There is no solid reason for this, assuming that the market anticipates fairly level inflation. It is my belief that this represents an additional risk premium for increased inflation in the future.

There is a solid reason; it is compensation for the inherent volatility of the very short term bill rate over time (see "bond risk premium")

But given the historical risk premium on the 10-year versus the 5-year Treasuries, there is an indication that the market prices an addition risk of higher inflation into the longer maturities. Presumably this premium would increase if inflation grew beyond the general 3% that has applied for the last quarter-century or so.

It is possible for markets to do that (expect higher inflation in the out-years) but it would also be reflected in the break-even inflation rates on equal-duration TIPS and in inflation swap spreads. 10 year TIPS normally trade at higher real yields than 5 year ones, which cannot be explained by your idea, but can be explained as compensation for the volatility of short rates.

Housing values, for example, have certainly not kept pace with inflation for the last 5 years (although they did very well for the five years before that).

Over long enough horizons housing has beaten inflation (and t-bills). In theory it should also, since housing is a claim on cash flows (rents net of upkeep costs--although many people consume the rental value themselves of course). Yes it may have long-lived cycles of optimism and pessimism; but then that's what risk manifests as and why investors are compensated for it.

 

[Francesca R]

Especially since the best investment mix depends somewhat on inflation, if you lock your money away for too long in a specific investment mix, you'll create opportunity losses for yourself if inflation is too high or too low. (For example, real estate and commodities tend to be poor investments in times of low inflation, bonds in times of high inflation.)

But this does not vary with the duration of the asset. The duration of equities and real estate is very much longer than that of bonds (equities usually never get redeemed, real estate usually has a finite life but often more than 10 years), yet it would not be correct to say that an investment in either is locked away (they are liquid--individual buildings aren't but pooled investment vehicles like REITs are), and neither of them (equity and real estate) are as sensitive to inflation expectations as bonds.

This is because they are claims on real cash flows, and inflation therfore affects both the numerator (the cash flow) and the denominator (the discount rate) of a DCF-based estimate of the fair value of a stock or a building.

(Commodities are not assets at all in my view--they generate no cash flows and should not be expected to return above zero for any reason other than unanticipated increases in scarcity.)

The demand (and therefore yield) for Treasuries therefore depends not only on how much inflation is expected, but also how stable it's expected to be (and therefore how long/reliable a planning horizon you have).

As per previous post, if the higher yield on longer duration Treasuries was some kind of increased compensation for inflation uncertainty in distant years, then this extra yield premium would not be observable in real return bonds like TIPS (which are insulated from all that), yet it is. (Not sure if you were arguing that, but the other poster was)

 

[JJM 777]

This goes back to John Locke's "justice in acquisition" and "justice in transfer" theories

In that context, "justice" means "legislation" = "what the state will do to citizens when citizens have done this or that". Law is a practical issue, don't think or interpret, just read and follow the letter.

 

[Francesca R]

Erm, no. Locke was a philosopher not a lawmaker. But denial does indeed appear to be your mindset. Forget it.

 

[Puppycow]

Good news: Janet Yellen will be the Fed’s new #2.

She’s open-minded, a good counterweight to the inflation hawks who think that any day now we’ll be partying like it’s 1979.

Report

WASHINGTON — The Obama administration has settled on Janet L. Yellen, president of the Federal Reserve Bank of San Francisco, to serve as vice chairwoman of the Federal Reserve, a senior administration official said on Thursday night.

Ms. Yellen, 63, who was chairwoman of the White House Council of Economic Advisers and a member of the Fed’s Board of Governors in the Clinton administration, was widely considered to be the front-runner for the position. She would succeed Donald L. Kohn, who intends to retire when his four-year term expires in June.

Ms. Yellen is viewed by some economists as relatively more inclined to keep interest rates low to stimulate economic growth and reduce the high rate of joblessness. The Fed now faces a tricky balancing act of trying to nudge rates up from historic lows while not choking off a recovery.
. . .
Ms. Yellen, a Brooklyn native who received her Ph.D. in economics at Yale, has taught in the Haas School of Business at the University of California, Berkeley, since 1980. She has published widely on a variety of macroeconomic topics and is an authority on unemployment.

Among her publications is a 2001 book, "The Fabulous Decade: Macroeconomic Lessons from the 1990s," written with Alan S. Blinder, a former vice chairman of the Fed.

Ms. Yellen’s husband, George A. Akerlof, is a Nobel Prize-winning economist who also teaches at Berkeley.

 

[UWdude]

And a Nobel laureate.

The Nobel prize in economics is not a Nobel prize.

from en.wikipedia org /wiki/Nobel_Memorial_Prize_in_Economic_Sciences


The official name is the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel



Not that the actual Nobel Peace prize ever meant anything since Kissinger, but the science prizes are still highly regarded. Regardless, economics are by and large a pseudoscience.

 

[UWdude]

That's not injustice, just luck and fate.

The universe isn't fair.

And this is the biggest conundrum of them all. We are taught economics are nothing but chance and luck.

But successful people, it is believed, got where they did because of "freedom" capitalism" "entreprenuership" and "hard work"

It is injustice, when a company gets rich of cotton pickin' slave labor, makes enough money to go into financing, and then becomes a major financier of the world.

It is injustice when one country raids another country, displaces their elected leader, and puts in the leader chosen by the United fruit Company. It is injustice when 200,000 people die under the new UFC regime, while the UFC shareholders light cigars with dollar bills as call girls pour them champagne.

Profits, exploitation, massive risk taking, and forced public payment for private losses isn't "luck"; it's injustice.

 

[drkitten]

And this is the biggest conundrum of them all. We are taught economics are nothing but chance and luck.

Perhaps you were. That doesn't speak well for UW if you were, though.

 

[drkitten]

Regardless, economics are by and large a pseudoscience.

Funny how the people who argue the loudest that economics are by and large a pseudoscience are generally also the ones who are the most convinced that they and they alone hold the simple answer to all the questions that have puzzled economists for centuries.

 

[UWdude]

Funny how the people who argue the loudest that economics are by and large a pseudoscience are generally also the ones who are the most convinced that they and they alone hold the simple answer to all the questions that have puzzled economists for centuries.

There is the study of the exchange of goods, and there is the study of charts, TA, and chaos models.

One is real economics, the other is psuedo science.

How do I know? Let me put it like this:

Taking perfectly functioning cars, and destroying them, is a damage to the economy.

Now, you can argue all day and all night about it. But I know, without a doubt in my mind, destroying what has been created may be good for some people, but for all people it is bad. I do not need a paper from a university to tell me this.

Perhaps you were. That doesn't speak well for UW if you were, though.

I called it a conundrum for a reason. I say "we" in the pluralistic sense, and I mean that through more than just schools, I mean through the great educator of the United States, the mass media.

 

[drkitten]

There is the study of the exchange of goods, and there is the study of charts, TA, and chaos models.

One is real economics, the other is psuedo science.

How do I know?

You don't. That's patently obvious.

Let me put it like this:
Now, you can argue all day and all night about it. But I know, without a doubt in my mind,

... and there's the proof. Whenever anyone announces that they know beyond the possibility of any data affecting their opinion, they've just announced that they're operating on pure prejudice, untouched by reason and evidence.

I called it a conundrum for a reason.

Yes, I know. Because you're poorly educated and ignorant, and you're projecting your own failures onto the field that you refuse to learn anything about.

 

[Kevin_Lowe]

Funny how the people who argue the loudest that economics are by and large a pseudoscience are generally also the ones who are the most convinced that they and they alone hold the simple answer to all the questions that have puzzled economists for centuries.

What's funny is how you attack the arguer habitually instead of presenting any argument or evidence.

The people who argued the loudest against the war in Iraq were extreme leftist loonies. Loonies argue loudly, it's a characteristic of the breed. Yet in that case they were right that the war was a dumb idea being sold with outright lies.

The people who argue loudest that (mainstream micro)economics is a pseudoscience are the loonies. Loonies argue loudly, it's a characteristic of the breed. Yet they are right that mainstream microeconomics is a pseudoscience.

That's why attacking the arguer is a fallacy. Sometimes idiots get lucky and state things which are true.