May 31, 2015 | Post by: Roman Chuyan, CFA Comments Off on Why We Need Inflation –

Why We Need Inflation –

As soon as the Fed’s policies are mentioned, most people think of a threat of dangerous, damaging, ugly… Inflation! This includes ordinary folks as well as “experts” – academics, billionaire hedge fund managers, and politicians.

Since the end of 2008, a chorus of experts and prominent citizens has predicted that the Fed’s unprecedented stimulus would lead to runaway inflation that would hit markets and potentially even debase the dollar – it’s summarized well in this article. The group included Stanford University’s John Taylor, billionaire hedge fund manager Paul Singer, House Speaker John Boehner and others. They were proven wrong. Core inflation remained below 2%, the lower end of the Fed’s target range, most of the time since 2009 (except briefly reaching a peak of 2.3% in 2012 (a peak of 3.9% for total inflation). Core inflation is now 1.76%. So, the Fed’s policies have not generated significant inflation so far, and likely won’t ever, because these policies are nearing an end.

Economic growth is typically associated with moderate inflation. Developed economies need moderate inflation in order to achieve potential real (ex inflation) growth and employment. Optimal inflation is typically considered to be 2%-2.5%. There is economic theory behind it, but let us just look at actual historical data. In the enclosed chart, I looked at the U.S. and France over the last 10 years. Unemployment was much lower in the U.S. than in France when U.S. inflation was higher. Inflation dropping to 1% spelled disaster for either country – unemployment rose above 9%. The bottom line is – we need inflation to stay close to 2%.

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