Should the Federal Reserve raise the inflation target to between 3% and 4%? That's the latest theory making the rounds among economics wonks. The idea is essentially that higher inflation will stimulate the economy by encouraging spending and making existing debt easier to pay down. My colleague Megan McArdle explained some of the big drawbacks from higher inflation yesterday. But even if there were no negative consequences, can we really be so sure that the purported benefits of higher inflation would materialize?

More Spending?

In a New York Times op-ed this week, Economist Tyler Cowen argues that consumers will want to spend more if the Fed targets higher inflation:

If the Fed promises to keep increasing the money supply until prices rise by, say, 3 percent a year, people should eventually start spending. Otherwise, if they just held the money, it would be worth 3 percent less each year.

I'm a little unclear how we can be so sure that consumers will choose to spend more if cash is worth less. Spending should still remain mostly dependent on psychology and economic expectations. If money is worth less, then consumers might simply turn to saving through options other than stuffing extra cash under their mattress. Maybe they'll buy gold or Treasury Inflation Protected Securities (TIPS) instead. They won't necessarily figure they might as well spend it.

Less Saving?

The other big benefit of higher inflation is that existing debt's relative cost will decline. As dollars are worth less, and nominal wages rise, old debt is easier to pay down. This could increase spending through a wealth effect, where consumers feel like they have more money as their debt declines, so they can spend more.

The problem with this logic, however, is that inflation also makes past saving worth less. So any money in 401ks or pensions suddenly won't be worth as much in retirement as people thought. That could actually encourage people to save even more, instead of spending more. This effect could be particularly problematic considering the size of the Baby Boomer population. They would be very concerned that their nest eggs may not provide for their retirement over the next few decades in a world with higher inflation. Their spending could actually decline even further in response.

Higher Nominal GDP Will Increase Optimism?

But might sentiment increase? After all, higher inflation will necessarily result in a higher nominal GDP. So people might view the economy as healthier, and be more willing to spend.

If they do, however, then they would fail to understand what's really going on in the economy. Real GDP is the proper measure of economic activity, because it subtracts the effect of inflation. For example, if nominal GDP is 3.5% and inflation is 4%, then the economy actually contracted by 0.5% over the year. There's little doubt that good business journalists would point this out, so any sort of dishonest optimism expressed through higher nominal GDP thanks to higher inflation shouldn't have much effect.

Nominal Wages and Employment Will Increase?

Nominal wages will also probably increase through higher inflation. But so will prices. As a result, consumers won't feel that their purchase power has really increased by much. Sure, any extra income will increase in value more than the cost of their debt, but as just mentioned, the decline in the value of their savings may wash out the effect on debt.

Moreover, it's not guaranteed that wages will increase as quickly as inflation. We have seen corporations become very cautious since the financial crisis. They're hoarding cash instead of expanding. Again, if their economic expectations don't change, then they might choose not to raise wages or hire more workers, but invest in inflation-protected saving options instead. Higher inflation doesn't guarantee better economic prospects, so sentiment shouldn't change.

Economists who champion a higher inflation target as a means of stimulus must be assuming that consumers aren't as rational as all this analysis assumes. Perhaps people won't think to save through inflation protected investments instead of spending. Maybe higher nominal wages will make them feel wealthier despite their purchasing power remaining mostly unchanged. Perhaps they'll fail to recognize that higher nominal GDP is meaningless if real GDP is flat. If consumers fail to consider such reasoning, then higher inflation might help break the grim psychology that grips Americans. But if they see through the tactic, and remain cautious, then a higher inflation target may have very little effect.

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