Is inflation too low?

Is inflation too low? On the surface, the question seems absurd — something that might be uttered while someone is awash in cocktails. But there are some serious economists, and several large retailers, who basically have urged the Federal Reserve Board to pursue a higher, yet modest, level of inflation.

Economists view inflation, defined as a general increase in prices and a decline in the purchasing value of money, as a not-so-hidden tax, which was especially true when it reached its U.S. peak of 13% in 1979. Others consider a modest annual inflation rate of 5% the key to boosting economic growth today.

 “A higher dollar may also make purchasing raw materials from foreign sources more expensive, which also drives up costs that will eventually be reflected in the price of a manufactured item.” — Kurt Bauer, president and CEO, Wisconsin Manufacturers & Commerce

In most cases and in most scenarios, economists consider low inflation to be good and high inflation to be bad, with high inflation considered to be any inflation over 5% per year, perhaps 10% per year, “depending on the economist you talk to and the specific situation,” says Morris Davis, academic director of the James A. Graaskamp Center for Real Estate at UW-Madison and a former economist at the Federal Reserve Board.

At the moment, inflation is running about 1% per year, which is lower than the Central Bank’s stated target rate of 2%. According to Davis, there are two arguments for why this might be bad: First, people and firms might have made plans assuming a 2% inflation rate; if they had known inflation was going to be 1%, they might have made different plans. “For this reason, the unexpectedly low rate of inflation might have had some unintended consequences,” he noted. 

Secondly, the credibility of the Federal Reserve is on the line. “If the Federal Reserve says it wants 2% inflation, and inflation is 1%, then the Fed should act or risk losing its credibility,” Davis stated.

When Davis worked at the Fed under former Chairman Alan Greenspan, it had an explicit dual mandate, as authorized by Congress: full employment and stable prices. This dual mandate has been in place since the late 1970s, and now Fed officials are talking about loss of credibility because the inflation rate is 1%, below their stated target of 2%. “It’s possible we could have a hyperinflation — we are certainly in uncharted territory in terms of monetary policy — but the more likely scenario is low growth and low inflation for the foreseeable future,” Davis stated. 

The case for inflating

Janet Yellen, President Obama’s nominee to succeed Ben Bernanke as Fed chairman, reportedly is a Keynesian economist who believes that monetary policy can be used to influence the business cycle and boost job creation. If at some point she decides to stimulate moderate inflation, it’s because she believes — as do other advocates of boosting inflation, such as Harvard economist Kenneth Rogoff — that rising prices help companies increase profits and higher wages help borrowers pay off debts. They also argue that low inflation increases the risk of deflation, which many economists believe has caused the Japanese economy to stagnate for years.

Yellen has indicated that Bernanke’s monetary intervention, known broadly as “quantitative easing,” has yet to run its course. The Fed had set a target of 6.5% unemployment in order to consider tapering its $85 billion in monthly bond purchases — the national unemployment rate dipped to 7% in November — but announced it would begin tapering this month. It’s not entirely clear when the Fed will begin to move short-term interest rates off the near-zero mark. 

Nathan Brinkman, president of Triumph Wealth Management, says the Fed is looking at unemployment first and inflation second, but unemployment has remained stubbornly high. Before the tapering decision, Brinkman noted the Fed’s quantitative easing policy had produced only modest economic growth, much to the dismay of its architects.

“There has been just enough economic growth to where they feel like it’s kind of working, but we don’t have the final paper on it yet,” Brinkman says. “As long as we see some kind of growth, it seems to be enough to sideline the folks with the bullhorns calling for the pullback in the bond-buying and also those pushing for inflation to move in an upward direction.”

Different-sized retailers look at inflation differently. The big boxes like Costco Wholesale Corp. and Walmart believe low inflation is squeezing their profit margins. Richard A. Galanti, chief financial officer for Costco, has long felt that “a little inflation” is beneficial because when prices are rising, the company can grow its profit margins and its sales. More recently, he blamed low inflation for Costco’s disappointingly low revenue growth. 

Meanwhile, the little guys barely talk about inflation, according to Jerry O’Brien, executive director of the Kohl’s Center for Retailing Excellence at UW-Madison, who acknowledges that inflation is not his area of expertise. However, retail operations are, and he frequently talks to independent retailers who are not so much concerned about low inflation as their own cost margins.

“What can happen with cost inflation, when their costs go up and the competitive market makes it impossible to raise their prices, is their margins go down,” O’Brien explained. “That could be a very big challenge, particularly for smaller retailers who already are trying to compete with some giant purchaser. If their costs go up, the big national companies can perhaps hold off on a price increase, and that really squeezes the middle and smaller retailers.”

In the late 1970s, when inflation was out of control, smaller retailers found themselves in the position where costs were rapidly rising, yet they wanted to keep their low-price image, and that’s where margin-condensing occurred. “It was always a case of who would be the first one to admit that they had to charge more,” O’Brien recalled. “Again, for the big national retailers, they might have supply on hand because they can afford to have bought ahead, so they might be able to put that off, whereas the mid-sized and small retailers who were doing more just-in-time inventory had a very difficult time not immediately passing along the costs. That’s a challenge for continuing to make a reasonable profit.”

Many recall what a destructive economic force hyperinflation was in the late 1970s, especially for Wisconsin manufacturers, and that was before Wisconsin became a force in exporting. Asked whether more modest inflation in the 5% annual range would be beneficial for the state’s manufacturers, Buckley Brinkman, executive director of Wisconsin Manufacturing Extension Partnership, expressed doubts. 

Brinkman noted that 16% of the jobs in Wisconsin are manufacturing jobs, and that 93% of the state’s $23.1 billion in exports are from the manufacturing sector, led by machinery ($7.3 billion), electrical machinery ($2.3 billion), and medical equipment ($2.3 billion).

“The thing that’s the big danger, and more of a danger than it was 20 years ago, is that we have a much more connected global market, so your ability to incorporate inflationary increases is limited by your competition around the world, not necessarily your competition down the block,” Brinkman stated. “That’s a big factor that plays into this whole equation right now.” 

Kurt Bauer, president and CEO of Wisconsin Manufacturers & Commerce, says inflation generally puts pressure on the Federal Reserve to control it. “If inflation rises, interest rates are likely to follow,” he stated. “That is tough on businesses, including manufacturers, who may need to borrow funds for a variety of reasons, including an expansion, equipment and inventory purchases, renovation, acquisition, etc. Inflation also means that the dollar buys less, which can result in workers and their unions, if applicable, demanding higher wage increases.”



Inflation coupled with higher interest rates also tends to drive up the value of the dollar, Bauer noted, so for most manufacturers, inflation equals cost increases. “It is low now compared to international currencies, which makes U.S.-made goods cheaper, but if the dollar’s value rises, then demand for U.S. manufactured items may decline because they will be more expensive, especially if international competitors are not experiencing similar cost increases, inflationary or otherwise.

 “A higher dollar may also make purchasing raw materials from foreign sources more expensive, which also drives up costs that will eventually be reflected in the price of a manufactured item.”

Bottling the inflation genie

A little bit of inflation is one thing, but what if inflation gets out of control again, especially as the economy recovers? If the Fed tried to engage in policies that would bring inflation to 5% per year, would it be playing with fire? Would the Fed be able to control the situation and avoid the economically debilitating hyperinflation, 10% and above, of the late 1970s?

Robert Samuelson, author of The Great Inflation, one of the definitive accounts of inflation in the 1970s, argues that inflation is difficult to manipulate with precision, in part because of the unforeseen ways people adapt. For example, once companies and workers understand that the government is encouraging inflation, they raise prices and wages much faster than expected.

Critics of quantitative easing worry about the potentially inflationary impacts of a massive increase in the money supply, which is reflected in roughly $2.3 trillion in excess bank reserves. But Fed governors have noted that these reserves are not, and will not be, loaned out by banks, and when it’s clear the economy has turned a corner, the Fed plans to soak up the excess reserves by selling Treasuries and mortgage-backed securities, or by entering into repurchase agreements and paying banks to hold excess reserves.

Whether avoiding an inflationary cycle is that simple, and whether it’s devoid of harmful unintended consequences, remains to be seen. Davis warned that a high inflation rate, especially if it lingers over an extended period of time, would not be good. “Any unexpected inflation redistributes wealth from lenders to borrowers,” he noted. “But even when inflation is fully anticipated, it is bad for everyone for a lot of reasons. The main one is that people and firms start spending time and energy trying to avoid the hassle and real costs of inflation, such as indexing contracts for inflation, raising prices and wages every three months, and devising tax shelters to avoid bracket creep on income taxes, since tax brackets change infrequently.”

In addition, high inflation could mitigate a global advantage the U.S. enjoys, Davis noted. The dollar has a special place as the world’s reserve currency, and people in other countries are willing to store dollars. “The benefits of this are large and not that well understood,” Davis explained. “We print up intrinsically useless pieces of paper called dollars. People in other countries accept them and store them in their mattress or bank, and then they provide to us useful goods and services in return.

“It’s a good deal, and we should try to preserve it. A large inflation would undermine the usefulness of the dollar as a reserve currency.”

In addition, a one-time, unexpected, and large burst of inflation would erode the real value of the currency and debt held by foreigners. It would, in effect, cause a large transfer of wealth from the rest of the world to the U.S. “I can see how some would advocate for this, but I am opposed since it is equivalent to a default on debt,” Davis opined. 

While O’Brien doesn’t consider himself an expert on inflation, he referenced Argentina when citing the chaos that can occur when inflation gets out of control. One recent survey pegs Argentine inflation at a debilitating 26.8%, prompting the government to seek “price accords” with businesses and other economic entities. Meanwhile, foreign investors are staying away from the country’s heavily regulated economy. “Literally, the government is stepping in and demanding that prices go down, which is absolutely insane,” O’Brien stated. “Nobody is investing their money there.”

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