Wednesday, July 2, 2008

The merits of inflation

An interesting speech by one of the PIMCO directors. The basic argument is that the US, as an oil importer is experiencing a negative terms of trade shock -- namely, higher oil prices -- and that the Fed shouldn't raise rates to deal with the inflation this causes because it makes labor pay the full cost of the shock, rather than sharing it between capital and labor.

Let me see if I can rehearse the idea. First, the price of oil goes up. In real terms, this means that you have to work more to buy a barrel of oil. Your real wage, as a nation, has decreased. The nation is composed of two groups -- those who labor, and those who hold capital. Let's assume for a second that holding capital means holding cash or T-bills or short-term assets in general. Now, if you raise interest rates to deal with this inflation, you can maintain the purchasing power of that cash. The Fed raises rates in the face of an inflationary shock in order to maintain stable real interest rates. Unfortunately, higher rates also make it less profitable to invest in real businesses, so they imply a slowing economy. This means that more people end up out of work, and those that remain employed see no wage increases. Therefore, the real wage declines, and has to account for all of the necessary adjustment to the decline in purchasing power of the nation. Labor suffers while capital (cash) skates.

If, however, the Fed leaves rates where they are, the real rate of return on short-term capital declines as the price of oil rises. This may even result in negative real interest rates. But this simply means that now some of the burden of the fall in purchasing power is partly absorbed by capital, and should protect labor from an economic decline. The lower rates should cut into economic growth less, meaning that fewer people lose their jobs and those that stay don't need to accept a reduction in (nominal) wages. So the purchasing power of capital is eroded along with labor if you keep rates low.

The problem is in dealing with the knock-on effects of negative real interest rates.

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