Higher Inflation: Scourge or Savior?

On Sept. 21 the Federal Open Market Committee announced it would make monetary policy even looser through what economists have dubbed “Operation Twist”—switching $400 billion worth of its Treasury holdings from short-term securities into long-term ones in a bid to bring down long-term interest rates.

High inflation isn’t the main risk, the rate setters said; weak growth is. The FOMC statement said the committee anticipates that inflation will wind up at or below its target range rather than above it in coming quarters “as the effects of past energy and other commodity price increases dissipate further.” The Fed’s implicit inflation target is 1.7 percent to 2 percent.

The Fed isn’t the only central bank that seems to be putting inflation worries on the back burner while fighting slow growth. The Bank of England has held its key rate at a record low even as U.K. inflation breached its 2 percent target for 21 months. Brazil executed a surprise cut on Aug. 31 to preserve growth even after inflation quickened to a six-year high.

Policymakers such as Fed Chairman Ben S. Bernanke and Bank of England Governor Mervyn King may be challenging orthodox thinking on inflation to support recoveries at risk of sliding back into recession, James Kochan, chief fixed income strategist at Wells Fargo Advantage Funds, said before the Sept. 21 Fed announcement. “There’s a hint of desperation here,” says Kochan. “They’re clearly concerned that monetary policy to date hasn’t really accomplished what they expected it to. So they ask themselves, why? And what could we do about it?”

If adopted, the new strategy might be called “Generate Inflation Now,” a reversal of the Ford Administration’s “Whip Inflation Now” in the 1970s, says Vincent R. Reinhart, who was the Fed’s director of monetary affairs from 2001 to 2007 and will become Morgan Stanley’s chief U.S. economist in October. Reinhart says the Fed might temporarily tolerate inflation as high as 3 percent if it adopted such a policy.

Columbia University’s Michael Woodford and Harvard University’s Kenneth Rogoff are among proponents of faster price increases. Consumers may shop more aggressively if they think prices are going to go up. There’s also the side benefit of helping pare record debt loads: If a company is charging higher prices in an inflationary environment, it’s easier to pay off old debt that charges interest rates below inflation. Inflation also makes government debt less difficult to retire.

There has been “nervousness” among central bankers about saying “you would allow inflation,” says Woodford, who taught economics with Bernanke at Princeton. Now “there’s at least more willingness to discuss the issue.” While computer simulations imply this strategy will work, it’s untested in the real world, says Woodford.

A policy of tolerating higher inflation means weaker developed-market currencies, including the dollar and pound, says Stephen Jen, managing partner at SLJ Macro Partners in London.

Pacific Investment Management Co.’s Anthony Crescenzi cautions that faster inflation may also reduce the number of goods and services strapped households and businesses could buy. That would cut production—and eventually incomes. “I thought we learned that lesson in the 1970s,” wrote former Fed Chairman Paul Volcker in the New York Times on Sept. 19. “That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth.” Volcker earned fame defusing inflation thirty years ago.

Any change in the tolerance of inflation at the Fed would face opposition inside the U.S. central bank. Richard Fisher, president of the Federal Reserve Bank of Dallas, told reporters on Sept. 12 that he couldn’t imagine trying to explain the shift to unemployed workers and others “who don’t want their income or meager savings eroded by price increases.” He was one of three officials to dissent from the August decision to keep rates near zero through at least mid-2013.

Of course, if central banks do decide to tolerate more inflation, they may have to squelch price increases later, risking harm to growth and “a serious disinflation,” said Raghuram G. Rajan, former IMF chief economist and a professor at the University of Chicago’s Booth School of Business. That seems like a gamble more central banks are willing to make.

The bottom line: If central banks allow more inflation, higher prices could make debt cheaper to pay off and stocks more attractive than bonds.

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