The Future of Inflation Part II: How Costly Is Inflation?

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Bibliographic details

• Authors: RUCHIR AGARWAL, MILES KIMBALL
• Published: April 12, 2022

Overview

• Article examines the costs and benefits of inflation and assesses trade-offs, focusing on single-digit inflation (excluding hyperinflation).
• Highlights disconnect between strong public aversion to inflation and small welfare costs implied by standard neoclassical models.
• Authors: Ruchir Agarwal and Miles Kimball. Published April 7, 2022.

Inflation costs (theoretical and cognitive)

• Theoretical neoclassical costs typically small; policymakers face three choices: address perceived dislike, modify models, or accept perceived harms as real.
• Main categories economists focus on:
  • Shoe-leather costs:
  • More frequent trips to the bank to avoid the “inflation tax.”
  • Peter Ireland (2009) estimates these costs equal 0.05 percent of annual income for 2 percent inflation.
  • Costs can be higher with market power (Lagos and Wright 2005; Kurlat 2019).
  • Misallocation of resources and menu costs:
  • Price stickiness causes relative-price distortions.
  • Menu-cost literature: Mankiw (1985); Akerlof and Yellen (1985).
  • Costs relatively small but rise with higher inflation.
  • Unpredictability:
  • Friedman (1977) linked higher inflation with higher inflation uncertainty, causing distortions and arbitrary redistribution.
• Cognitive costs (confusion and sentiment) may be the most serious:
  • Real-world information processing is costly; confusion from inflation is hard to quantify but substantial.
  • Examples: blaming inflation for lower-than-desired real wages; tax-code distortions; mistaking nominal for real returns in retirement planning.
  • Shiller (1997) found public perceives inflation as harming standard of living, amplified when price increases are attributed to greedy actors without wage increases.
• Consumer-confidence evidence (1980–2021, six major economies, OECD data):
  • Higher inflation associated with lower consumer confidence across countries.
  • At zero inflation, a 1 percentage point increase in inflation has the same impact on confidence as a 1 percentage point increase in unemployment.
  • Adverse impact is greater at higher inflation levels and is well captured by a quadratic function centered just below zero inflation.
  • Conclusion: even low inflation is perceived as costly and costlier than neoclassical models suggest.

Inflation benefits

• Two primary benefits that underpin many central banks’ 2 percent target:
  • Reduced risk of hitting the zero lower bound:
  • Zero or negative inflation targets increase the risk of hitting the zero lower bound (ZLB), restricting central bank policy space via lower nominal interest rates.
  • Woodford (2003) conventional models suggest optimal inflation target is zero, but central banks have adopted 2 percent.
  • Real rates have declined over time; central banks have faced the ZLB or effective lower bound for several years (Chart 2 referenced).
  • Central banks respond asymmetrically around the 2 percent target—tolerating inflation below 2 percent but acting as if costs above 2 percent are high (Chart 3 referenced).
  • Overcoming downward wage stickiness:
  • Firms find it harder to cut nominal wages than to raise them; pay cuts may harm morale more than layoffs (Bewley 1999).
  • Higher inflation can facilitate real-wage adjustments via nominal confusion; traced to Keynes (1936).
  • Such adjustments can be beneficial when wages are misaligned with the marginal product of labor.
• Two medium-sized potential benefits:
  • Financial-stability benefits:
  • Higher nominal rates from higher inflation may make it harder for Ponzi schemes, irrational bubbles, and zombie firms to persist.
  • Low nominal rates can hide deterioration in borrowers’ net worth by reducing monthly loan payments relative to income.
  • Antitrust and deregulation effects:
  • Higher inflation may politically encourage price-lowering deregulation and antitrust efforts (historical example: US deregulation in the 1970s).
• Debt-overhang considerations:
  • Inflation can reduce real debt burdens but is a transfer from creditors to debtors, with equal and opposite wealth effects.
  • Net welfare benefits of an “inflation tax” are likely small; better to pursue distributional objectives via fiscal policy.
  • Use of inflation as debt relief raises the risk premium on future debt due to expectations of repeated use.

Fundamental trade-off and policy scenarios

• Fundamental trade-off: weigh cognitive costs to households against macroeconomic benefits (avoid ZLB and ease wage adjustments).
• Status quo explanation for 2 percent target:
  • Central banks internalize ZLB benefits but households bear cognitive costs, producing tolerance for permanent 2 percent inflation despite household aversion.
  • The 2 percent number is a convention arising from central bank practice rather than an intrinsic macroeconomic law.
• Two possible future scenarios:
  • Scenario 1 — Status quo continues:
  • Alternation between (a) long periods of sluggish growth at the ZLB with inflation below 2 percent, and (b) periods of normal growth away from the ZLB but with cognitively costly average inflation of 2 percent (with occasional spikes above 2 percent).
  • Scenario 2 — Innovation and norm change:
  • Wider recognition that the ZLB and wage stickiness are policy/norm-dependent, not immutable.
  • Innovation in macro tools could “break” the ZLB and evolve toward a modern “share economy” with more flexible labor compensation (e.g., Weitzman’s share-economy idea of annual bonuses).
  • With evolving labor norms (teleworking, gig economy), Weitzman’s proposal merits revival.
  • Authors predict that as macro innovation expands, benefits of positive inflation will fade and inflation will tend toward zero.

Policy implications and recommendations

• Consider addressing cognitive costs directly (public communication, reducing confusion in taxes and financial contracts).
• Prefer fiscal and structural policies over inflation as a tool for redistribution or debt relief.
• Develop and deploy macro-policy innovations to reduce reliance on positive inflation for avoiding the ZLB:
  • Options to break through the ZLB are available in the literature (Agarwal and Kimball 2015; Agarwal and Kimball 2019).
  • Encourage reforms that increase wage flexibility (e.g., greater share-based or bonus compensation) to reduce need for positive inflation to reallocate real wages.
• Promote policies that target financial stability and antitrust/deregulation directly instead of relying on inflation to produce such outcomes indirectly.

Key numeric and dated references preserved exactly

• Article published on April 7, 2022.
• Focus on single-digit inflation; hyperinflation excluded from scope.
• Ireland (2009) estimate: 0.05 percent of annual income for 2 percent inflation.
• Consumer-confidence comparison period: 1980 and 2021 across six major economies.
• Illustrative example: yard length question—“This year the yard is 36 inches.”
• Central-bank inflation target referenced: 2 percent.
• References to works dated: 1969 (Friedman), 1977 (Friedman), 1985 (Mankiw; Akerlof and Yellen), 1986 (Weitzman), 1991 (Summers comment), 1997 (Shiller), 1999 (Bewley), 2000 (Lucas), 2003 (Woodford), 2009 (Ireland), 2015 and 2019 (Agarwal, Kimball), 2016 (Mankiw), 2022 (Krugman).

Summary derived from “The Future of Inflation Part II: How Costly Is Inflation?” by Ruchir Agarwal and Miles Kimball, F&D Magazine, published April 7, 2022.