Controlling Inflation Essay

Within the scope of this research, we will analyze article written by Mark Gongloff and entitled “The Fed’s deflation dread”. The article is filled with opinions of professional economists and corporate finance professionals, which are good examples of the analysis to be performed. In order for the analysis to be more useful, the subject to be reviewed will be narrowed down to one particular topic – how Federal Reserve is able to use ‘zero inflation’ in order to control inflation/deflation.

“The Fed cut its target for a key overnight bank lending rate by an aggressive half a percentage point Wednesday to a 40-year low of 1.25 percent in a bid to make borrowing cheaper and prod U.S. consumers to keep spending, and carrying the economy.”(Gongloff article) The very first words of the article lead to the concept ‘zero inflation’. The argument for zero inflation rests on two pillars.

The first is that the costs of even a fairly low rate of inflation are quite high, while the output and employment costs of maintaining zero inflation are low. The argument that has often been made is that inflation makes it hard for people to plan for their retirement because they are unaware that when they retire a dollar will be worth much less than it is worth today. Consequently, they save too little.

A more sophisticated argument considers the interactions of the tax system with inflation. Since people are taxed on their nominal and not their real returns, inflation increases the effective tax on income from savings. For example, suppose that someone puts $1,000 into a savings account with an interest rate of 3 percent. Suppose also that this person has to pay income tax of 33 percent on interest income. At the end of the year this person will have earned $30 of interest and paid $10 of that as taxes.

If there is no inflation, the real purchasing power of his or her savings will be $20 or 2 percent higher at the end of the year. Now, suppose instead that the inflation rate is 3 percent. Suppose also that the nominal interest rate is 3 percent higher as well (6 percent), so that the real or inflation -adjusted rate of interest remains the same. Now this person earns $60 in interest and pays $20 in taxes. The savings account at the end of the year contains $1,040. While the nominal value of the savings is higher, the real purchasing power of that savings is, however, lower.

Thanks to the 3 percent inflation, that $1,040 can buy only as much as about $1,010 would have in the absence of any inflation. Taxes and inflation have left this person with only about $10 worth of real gains instead of $20 – the effective tax rate on savings for this person has risen from one-third to about two-thirds because of inflation. If the tax system were indexed – that is, if people were taxed on the gains in the purchasing power of savings rather than its nominal value – this would not be a problem. But that is not the case, of course.

While this effect may be small in any single year, it can add up to big losses by retirement. In the end, savings are much lower than they otherwise would be. According to this argument, it would be feasible for savers to lay aside a little bit during their working lives and have a comfortable retirement. But even at low rates of inflation, the tax system takes away so much from the return on their savings that they are denied this opportunity.

“The loss in the welfare of savers because of the denial of this opportunity, year in and year out, would be valued at almost 1 percent of Gross Domestic Product.” (Bade et al, 2006) If lower savings means less investment, we get less growth and ultimately lower wages and employment as a result. When these effects are combined with other smaller distortions caused by inflation, advocates of a zero target claim that the gains from reducing inflation to zero could be equivalent to even more than 1 percent of GDP.

The second pillar on which the argument for zero inflation rests is the “natural rate” theory of unemployment. According to this theory, there is only one level of unemployment that is consistent with constant inflation. If the unemployment rate rises above this level, inflation will fall. If the unemployment rate falls below this level, inflation will rise. If unemployment is at the natural rate, the level of inflation will remain constant.

If we are at the natural rate of unemployment today with 3 percent inflation, then if we keep our unemployment unchanged, the theory states that inflation will remain at 3 percent. If we increase the unemployment rate even a tiny amount, goes the theory, the rate of inflation will begin to fall. It will continue to fall without limit, eventually becoming accelerating deflation. If we again lower unemployment to the natural rate, when inflation reaches zero, we would be able to maintain zero inflation as long as the unemployment rate remained at the natural rate.

In other words, the theory maintains that any rate of price inflation, including zero, is attainable if unemployment is at the natural rate. Higher unemployment may be necessary to reduce inflation in the short run, but in the long run, zero inflation, or any other rate, could be maintained indefinitely if unemployment is simply kept at the natural rate. Thus, the benefits of low inflation can be obtained in perpetuity by paying a one-time cost of higher unemployment for a short period of time in order to reduce the inflation rate.

The magnitude of the gains that have been claimed for obtaining zero inflation are easily disputed. The fast argument for reducing inflation to zero suggested that people do not understand that, with inflation, a dollar will not be worth as much when they retire as it is today. But if people cannot intuit the effect of inflation on their retirement savings, can they intuit the effects of compound interest over time? If they ignore both in planning for retirement, they will oversave, not undersave.

Second, the potential tax consequences for savings are most important for retirement savings, where they accumulate over many years, but the great majority of retirement savings is sheltered from these tax consequences through pensions and other tax-deferred savings plans. Finally, of course, low savings rates need not translate into low investment rates, since our capital markets are open and allow foreign investors to take advantage of opportunities that we fail to seize.

Even if the gains from zero inflation are much smaller than what has been claimed, the compelling logic remains that for a one-time cost today we can reap the benefits of zero inflation forever. But can we maintain the same high level of employment with zero inflation that we now have with 2 to 3 percent inflation? This is the critical issue. (Bade et al, 2006)

In both the best of times and the worst of times the economy creates many winners and losers. That is one of the most important findings of economic research in the last fifteen years. The changes in the fortunes of individual firms dwarf the tides in the microeconomy. “In a normal year, about 10 percent of all jobs disappear, while new jobs equal to about 11 percent of the work force are created.” (Bade et al, 2006)

Desired wages and wage changes differ across firms as well. Thus, no matter what the aggregate economy is doing, some firms are contracting and cutting their labor costs while others are expanding. Expanding firms may pay higher wages to attract new workers, to ensure the loyalty of their work force, or they may negotiate higher wages as part of a collective bargaining agreement. Firms that are contracting would want to cut their relative wages to preserve employment.

At moderate rates of inflation and relative productivity growth those firms that need to reduce wages can do so by allowing their wages to grow at a slower rate than average.

The firms that are doing well can increase their wages faster than average. When inflation and productivity growth are both very low, however, the only way unlucky firms can reduce their relative wage is by actually cutting wages. Since the early 1970s, productivity growth in the United States has averaged slightly less than 1 percent per year. (Bade et al, 2006) Thus, without moderate inflation, many firms would have had to cut wages to maintain employment.

The problem is that in reality, employers almost never cut wages. They may let inflation erode the buying power of wages, but in study after study employers express the sentiment that a cut in money wages would cause serious morale and worker retention problems. Studies of popular sentiment suggest why. Most respondents consider it unfair for a firm to cut wages except in extreme circumstances. On the other hand, the majority does not consider it unfair if a firm fails to raise wages in the face of considerable inflation. (Bade et al, 2006)

Microeconomists of the 1950s and 1960s understood the importance of this “downward nominal rigidity” in wage setting for the relation between inflation and unemployment. But today’s microeconomists do not worry as much about downward nominal rigidity as those of the past for a number of reasons. For one, the continual inflation of the postwar period has meant that the downward rigidity of wages has not played much of a role in economic-behavior. For another, the growth of the rational-expectations school in microeconomics has led many economists to shy away from models in which people may behave in ways that are inconsistent with fully rational, self-interested behavior.

Caring about nominal rather than real wages would be an example of irrational behavior, according to these models. Furthermore, several authors have claimed that the rigidity of nominal wages is not a fact in practice. It is therefore worth reviewing the evidence on nominal rigidity. It is also important to explore more carefully than has been done in the past the impact of wage rigidity on unemployment at very low rates of inflation.

If zero inflation were really costless in the long run, then the benefits its advocates have proposed would make it an attractive target for Federal Reserve policy. However, zero inflation would not be costless. Inflation greases the economy’s wheels by allowing firms in distress to escape slowly from a commitment to pay high wages so that the economy avoids a large employment cost. At very low rates of inflation this becomes hard to do. At zero inflation, it is almost impossible.

Bade, R. and Parkin, M. Foundations of Macroeconomics (3rd Edition). Addison Wesley, 2006.
Gongloff, M. “The Fed's deflation dread”, November 7, 2002. Available at:
Klevorick, Alvin K.; MacAvoy, Paul and Peltzman, Sam. "Directions and Trends in Industrial Organization: A Review Essay on the Handbook of Industrial Organization." Brookings Papers on Economic Activity. Microeconomics, 1991, 1991, pp. 241-80.