Is Inflation Too Low?

W hat is today’s big monetary policy issue? It is, surely, the extraordinary volatility of the financial markets and the wide quality spreads that opened up between riskier bonds and Treasury bonds following the Russian default in mid-August 1998. No one forecast these problems; the financial-market upset certainly was not a real, live policy issue back in the spring and early summer. We should not underestimate the magnitude of the current disturbance in the U.S. financial system. Monetary policy today is, I believe, appropriately focused on dealing with the possible effects of the financial-market disturbance on the U.S. economy. The size of that disturbance and the circumstances surrounding it are so unusual in the context of U.S. history that policymakers must concentrate on dealing with this situation for the time being. The financial upset, however, will disappear from the radar screen of pressing policy issues as the markets settle down in due time. All of us will then return—or should return—to analyzing longer-run issues. With regard to the current outlook, I will say only that I am optimistic that we will work through current problems, painful as they have been for many, with no significant damage to the U.S. economy. My optimism stems from the economy’s strong initial conditions of low inflation, low and stable inflation expectations, and a well-capitalized banking system. These are about as favorable a set of initial conditions as one can imagine for getting through financial turmoil with minimal effect on the real side of the economy. The issue I wish to explore is this: Is zero inflation, abstracting from measurement error in the broad price indexes, too low? I think zero is a very nice number, especially when it comes to inflation. But there is a serious argument that the economy is likely to work better with a moderate inflation of, say, 2 or 3 percent per year. I disagree with that argument. I will concentrate on two arguments for moderate inflation. The first argument holds that inflation facilitates the smooth operation of labor markets and thereby promotes maximum employment in the face of nominal wage rigidity. The second argument contends that inflation, via the Fisher relationship, keeps nominal interest rates from falling too close to the zero bound, and thereby gives the Fed sufficient room to ease—that is, to cut rates—should a recession appear imminent. In my view, both arguments are wrong. I will begin by outlining some reasons why I believe that zero inflation should be the paramount objective of monetary policy.