Can We Inflate Our Way Out of This Mess?

by Dual Income No Kids on May 19, 2009 · 0 comments

Hi All,

Sometimes you read a news story and it hits you in the face like a brick.

Evidently Harvard economists Greg Mankiw and Kenneth Rogoff are advocating that the US central bank adopt a target inflation rate of 6%. Their rationale is that the US has taken on a huge amount of debt and they argue inflation will facilitate deleveraging by reducing the real value of debt and stimulate spending by removing peoples incentive to save.

Some excerpts from their Bloomberg article:

““I’m advocating 6 percent inflation for at least a couple of years,” says Rogoff, 56, who’s now a professor at Harvard University. “It would ameliorate the debt bomb and help us work through the deleveraging process.”

Such a strategy would be risky. An outlook for higher prices could spook foreign investors and send the dollar careening lower. The challenge would be to prevent inflation from returning to the above-10-percent levels that prevailed in the 1970s and took almost a decade and a recession to cure.

“Anybody who has been a central banker wouldn’t want to see inflation expectations become unhinged,” says Marvin Goodfriend, a former official at the Federal Reserve Bank of Richmond. “The Fed would have to create a recession to get its credibility back,” adds Goodfriend, now a professor at Carnegie Mellon University’s Tepper School of Business in Pittsburgh.” (Bloomberg).

This policy may seem like a good idea, but please don’t underestimate the impact inflation will have on your bottom line.

1) Your savings will lose value. Lets assume you’ve got $1,000 squirreled away. If inflation runs at 6% for only two years, then your thousand would only buy about $883.00. That’s $116 bucks, up in smoke. This makes the processes of savings and investment a great deal harder. This is important because saving is a first step to building any sort of real wealth.

2) Generally speaking if you have anything that generates a fixed income, you’ll lose out. For example, if you have a CD – the best current rates are a little over 2.5% – you’d effectively be losing 3.5% on your CD if inflation is at 6%. You’d get a similar situation if you held bonds or fixed payment annuities.

3) Cost of living adjustments lag behind inflation. In periods of high inflation your salary, pension or government benefits may get an adjustment to account for the reduced power of the dollar. However, the effects of inflation are immediate and usually adjustments lag behind this. So, you’d be stuck with higher prices.

So, the reason why these sorts of editorials are so maddening is that while inflation might have some beneficial effects for the economy, Joe and Jane average will get the monetary equivalent of a sharp stick in the eye. If inflation does increase it will require much frugal living regardless of your income, as well as an ability to increase your wealth at a faster pace.

If you want more from these guys, check out Greg Manikow’s blog or Ken Rogoff’s faculty profile.

Best,

James

Update1: If you want to profit from inflation, the Digerati Life has a good posting on 12 moves you can make to cope with rising interest rates (DL).

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