Inflation Expectations: A Two Edged Sword

New Keynesians (and sometimes Scott Sumner) have argued that the U.S. economy needs higher expected inflation. For the new Keynesians, the rationale is that real expenditures are below the productive capacity of the economy and lower real interest rates will help to raise real expenditures. Firms will respond by expanding production and employment, bringing real output towards potential. Usually, given expected inflation, lower nominal interest rates would have the same effect. With the Federal Reserve's target interest rate near zero, however, lowering nominal interest rates by lowering that target rate is no longer possible. The argument for higher expected inflation is an argument about aggregate demand.

New Classical economists have sometimes responded to these arguments by claiming that higher expected inflation will have no effect on real output. They aren't making an argument about aggregate demand. They are making an argument about aggregate supply. If inflation is equal to the expected level, then real output will equal potential. It is only when inflation deviates from the expected level that there is some transitory effect on the willingness to produce goods and so some impact on real output and employment.

New Keynesians generally have a different approach to aggregate supply. Inflation depends on past and expected future levels, and also on the output gap, the difference between real output and potential. Even so, an increase in expected inflation implies that more current inflation will be associated with any expansion of real expenditure necessary to close the output gap.

From a market monetarist perspective, both real output and inflation respond to more rapid growth of nominal expenditure on output. Higher expected inflation should result in a division more weighted towards current inflation and less towards real output. And so, generating higher inflation expectations to reduce real interest rates, or perhaps, increase the expected cost of holding currency (which amounts to the same thing,) in order to raise aggregate demand has undesirable effects on aggregate supply.

Now, turn this argument about. Currently, nominal GDP is on a much lower growth path compared to the Great Moderation. My measures show nearly 14 percent lower. If potential output is on the same growth path as before, then for real expenditures to return to potential, both prices and nominal wages need to fall to a 14 percent lower growth path as well. Wage rates have hardly budged and the price level is on a 2 percent lower growth path.

The CBO estimates of potential output show a growth slow down for the last decade. Using those measures, real expenditure is about 7 percent below potential. Given the current level of nominal GDP, a 7 percent decrease in the growth path of prices and nominal wages would raise real expenditures to close the output gap.

The natural rate hypothesis suggests that this should be occurring. The 2 percent drop in the growth path of prices is but a drop in the bucket. One possible explanation is that the CBO estimates are too optimistic, or more accurately, not pessimistic enough. It must be that potential output shifted to a 14 percent lower growth path.

However, suppose that there really is an substantial output gap. If there were a reasonably prompt decrease in the growth path of prices and wages, this would involve transitory deflation. For example, if the price level needed to shift down another 12 percent (14% minus the 2% already accomplished,) if this were done over 4 years, there would be 3 percent deflation each year. Unfortunately, this would imply higher real interest rates, at least for the short and safe assets with nominal rates currently near zero.

Of course, the Chairman of the Federal Reserve, Ben Bernanke, loudly proclaims that the Fed can and will prevent any such deflation. One reason for his insistence is to keep expected deflation from raising real interest rates and reducing aggregate demand. However, at the very same time, efforts to keep expected inflation up interfere with the deflation in prices and wages need for the current growth path of nominal expenditures to generate sufficient real expenditures to close the output gap.

Lower expected inflation, and the short run aggregate supply curve increases, raising real output and employment, given aggregate demand. But, lower expected inflation, raises the real interest rate, lowers aggregate demand, and so lower real expenditure results in reduced real output given short run aggregate supply.

Suppose the output gap is entirely ineffective in motivating disinflation. Past inflation rates and expected future inflation rates determine the actual inflation rate. The Fed, with all of its credibility and record, insists that the inflation rate will be 2 percent. Believing this, firms and workers set prices at 2 percent. Sure, the output gap implies surpluses of labor and even output, especially if we imagine nominal wages being forced down to market clearing levels, but even so, prices and wages just continue on the path they would if the credible, 2 percent target were consistent with market clearing. If prices (and wages) do rise more slowly, this is followed by actions by the Fed to convince people that this is just a one time fluke, and prices will again return to rising on target.

Could the Fed's effort to prevent disinflation from raising real interest rates and so reducing aggregate demand be interfering with the market process by which short run aggregate supply shifts and brings real output and unemployment to natural levels? Could this be the reason for the pattern of the Great Moderation where recoveries in employment were so gradual? Sure, the other two recessions were mild, but they were very persistent.

Could inflation targeting be responsible? Does inflation targeting (a growth rate target) generate expectations that make it difficult to close an output gap, (a problem with levels?) The gold standard fixed the level of the price of gold. A money supply rule fixed (I guess,) the growth path of the quantity of money. A price level rule fixes the growth path of prices. Of course, market monetarists advocate targeting the growth path of nominal GDP.