Does The Economy Need A Little Inflation?

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Though most central bankers hate inflation, policies that promote inflation may boost the U.S. economy, some economists say.

Ken Rogoff, former chief economist at the International Monetary Fund, says the Federal Reserve's efforts to boost growth haven't worked and the central bank needs to be more forceful.

"They need to be willing, in fact actively pursue, letting inflation rise a bit more," says Rogoff, who is now a professor at Harvard. "That would encourage consumption. It would encourage investment. It would bring housing prices into line."

Inflation would push up the price of houses, meaning more people would actually have equity in their homes again. And the rising prices would bring both buyers, who've been waiting for prices to fall more, and sellers, who don't want to sell at a loss, back into the market. In addition, Rogoff says, higher inflation would help debtors, by allowing them to pay back their debts with cheaper dollars.

"Now you can say this is awful — that's like the '70s," Rogoff says. "It was terrible and many people have said that. But, you know what, we need still to be worried about the 1930s" and make sure we don't end up in that kind of long-term crushing slump.

Reviving A Prescription

Rogoff says the Fed should announce that it will essentially print money until inflation rises to around 5 percent a year. A few years ago, Rogoff says, this was the prescription one very prominent economist suggested that Japan use to get out of its deep economic funk.

"When Ben Bernanke, as a Fed governor went to Japan seven years ago, that's what he told them to do," Rogoff says. "I think it's the right recipe for the United States."

During a speech in Tokyo in 2003 Bernanke said, "I think the Bank of Japan should consider a policy of re-inflation." He went on to say, "One benefit... would be that it would ease some of the pressure on debtors and the financial system generally."

Stanford economist John Taylor, a former Treasury official under President George W. Bush, says re-inflation is not a good idea for the U.S. He says Bernanke offered that prescription for Japan because it was facing dangerous deflation in its economy, while prices are still rising in the U.S., at a rate of about two percent a year, excluding volatile food and energy prices.

"The idea that you could temporarily have some high inflation and deal with these problems is really wishful thinking," Taylor says.

He says encouraging inflation is a slippery slope. A central bank may just want to raise inflation moderately, but he says, it inevitably gets translated into higher inflation for longer periods. That's partly because pushing inflation down can cause economic pain, so people resist it.

"That happened in the [1970s]. Every time the Fed tried to reduce inflation there was huge clamoring for the harm that would cause the economy," Taylor says. "Finally, Paul Volcker with extraordinary courage and skill was able to bring that inflation down."

Former Fed Chairman Paul Volcker expressed his opposition to boosting inflation in a recent op-ed piece. Among his concerns is the effect on foreign countries that own trillions in U.S. debt. They would see the value of that debt eroded by higher U.S. inflation. Taylor agrees that's a problem.

"The idea of inflating ourselves out of our debt, the government debt in particular, raises huge credibility problems," Taylor says.

Ken Rogoff argues that fears the Fed could not get inflation back to desired levels after allowing it to rise a few percentage points are overblown. But it's not a painless solution, he says.

"I don't want to sound like this is a panacea, but it's certainly not something to be afraid of, it's not the major problem," Rogoff says.

The major problem is an outcome that looks more like the 1930s or Japan's lost decade. There are no easy solutions, Rogoff says. We're faced with picking our poison. A temporary round of higher inflation, he argues, is the least worst option.

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