At this writing, the economy is still in a severely depressed state, with the unemployment rate at 9.4 percent (the "underemployment" rate, which includes workers who have stopped looking for jobs and workers who are involuntarily working only part time, has risen to 16.4 percent), with a continuing surge in the personal savings rate (now 5.7 percent, up from 4.2 percent a month ago and 1 percent at this time last year), and with other shoes expected to fall soon: massive credit card defaults, a sharp decline in commercial real estate values, and an accelerating number of home foreclosures. Many economists believe that, with the economy so depressed, inflation is not a serious risk.
To evaluate that belief requires distinguishing between the short run and the long run--more specifically between a depression period (a bust) and a recovery period (a boom). Policy prescriptions tend to reverse at the ends of the business cycle. In a boom, thrift is good policy, to prepare for the inevitable bust, but in a bust, thrift is bad policy, because it reduces consumption and hence production; that is why the increase in the personal savings rate at this time is ominous. In a boom, inflation is a bad policy, because (among other things) it creates, as we know, asset-price bubbles. But in a bust, inflation is a good policy. This is partly because the biggest risk in a bust is a deflationary spiral, when as a result of falling prices the purchasing power of the dollar rises. Debts now become a crushing burden, because they are fixed in nominal terms and thus increase in real terms when they have to be repaid in dollars worth more than dollars were when the money was borrowed. And hoarding rises, because in a deflation the purchasing power of money increases even when it is just sitting in a safe-deposit box. Interest rates soar in real terms: if prices are declining at a rate of 2 percent a year, a nominal interest rate of 6 percent becomes a real interest rate of 8 percent, because a 6 percent increase in the number of dollars one has is the equivalent of an 8 percent increase in purchasing power. In effect, then, idle cash earns 2 percent interest. And the more dollars that are hoarded, the less economic activity there is.
Inflation can offset deflation. In the example I just gave, a 2 percent inflation rate will eliminate the deflation. But a higher inflation rate would be even better (within limits), because inflation operates as a tax on cash balances, and hence on hoarding, and the higher the rate of inflation, the heavier the tax and so the less hoarding. Suppose as before that deflation is 2 percent, and the Federal Reserve manages to increase interest rates by 4 percent. Then cash balances will erode by 2 percent a year, and this will induce the hoarders to put their cash to work, either in consumption or in active investment.
Moreover, inflation reduces the real wages of workers by raising prices, while if prices are falling real wages will be rising even if workers receive no raises: the same dollars will buy more goods and services. A reduction in real wages reduces labor costs, which encourages companies to do more hiring, and thus reduces unemployment. Workers in a depression will tend to accept a reduction in their real wages because they fear being replaced by what Karl Marx called "the reserve army of the unemployed."
Perhaps most important in the current economic situation is that, as I have already noted, inflation reduces the burden of debt. This is important for banks, but also for homeowners who have fixed-payment mortgages (as opposed to adjustable-rate mortgages). Even if a homeowner's nominal wage does not rise--and therefore, if there is inflation, his real wage falls--if inflation causes the market value of his house to rise he will have greater equity in the house and so will be less likely to default.