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Higher inflation would be good news for the US economy



While the central bank funding rate is fixed at zero, a lower inflation rate pulls the real interest rate down and, thus, further suffocates the demand.


Central banks create so much money because they cannot multiply their own money as they don't accept deposits.

Contrary to the concerns, a higher inflation rate would be good news for the economy. If the Fed policies were successful, the inflation rate would rise signing a closing gap between the demand and potential output.

Central banks' effort to boost expenditure may fall short when banks halt credits, anticipating a soaring delinquency rate.


Definition of inflation


Policy makers aim to realize the potential output which can be produced at the full production capacity. A demand higher than the potential output produces inflation whereas a demand lower than the potential output results in a recession. Recession and inflation are two opposite indicators. Inflation, hence, cannot be a concern for the US economy during a recession.


Why do trillions of new dollars not raise inflation?


People get confused with the trillions of dollars printed by the Fed. In fact, the Fed creates so much money because even trillions do not boost expenditure. But why? The reason lies on the money creation mechanism. As articulated here, money is largely created by banks.

Banks can multiply the central bank money. To illustrate, borrowing $100 from the Fed, a bank creates a loan. The loan is deposited in a bank account. Thus, total bank deposits rise a $100. As the loan is spent, it is transferred to other bank accounts without changing overall deposits. Banks can make new loans out of new deposits and, thus, multiply the central bank money over and over.


Aside from banks, central banks do not multiply their own money as they don't create loans. The Fed creates central bank money in return of securities. Sellers of securities deposit the Fed money in the banks. When banks don't make new loans out of new reserves, the money supply merely rises as much as the asset purchase amount. Therefore, asset purchases need to be in great amounts in order to boost expenditure.


Inflation signals recovery


Central banks' effort to boost expenditure may fall behind when banks halt credits, anticipating a soaring delinquency rate. As demand remains below the potential output, prices constantly deflate. While the central bank funding rate is fixed at zero, a deflationary trend slashes the real interest rate and, thus, further suffocates demand.


Contrary to the concerns, a higher inflation rate would be good news for the economy. If the Fed policies were successful, inflation would rise signaling a closing gap between demand and potential output. In such an environment, enhanced revenues would encourage businesses to hire new workers. In 2008, Fed tools such as quantitative easing and forward guidance promoted spending by reducing long-term interest rates. Nevertheless, this time, unconventional tools poorly perform due to already low long-term interest rates.


Once inflation is back, monetary tools qualify to keep it at the target. The Fed can shrink the balance sheet, raise the funding rate and restrain bank leverages via introduction of countercyclical capital buffer. Dealing with high inflation does not appear to be challenging with the tools that have already proven effective.


Spiral of deflation and recession


Bad news for economies amid COVID-19 would be a downward trend of prices due to the lack of demand. While nominal interest rates are at the zero lower bound, a falling inflation increases real interest rates. Deflation creates the spiral of higher real interest rates, lower spending and lower inflation. This spiral would constantly dampen prices of goods and services and exacerbate the recession.


For the US, a long-lasting and drastic recession such as the Great Depression would be the worst scenario in terms of inflation. Due to massive business shutdowns, a permanent fall in the production capacity would expose the economy into inflation. While potential output is down, fiscal and monetary authorities can boost demand up to a lower level without causing permanent inflation.


Conclusion


The risks are not symmetric below and above the inflation target. Central banks are equipped by necessary tools to keep inflation from rising whereas they are incapable of stimulating inflation at the zero lower bound. A dropping inflation would constantly dampen spending via higher real interest rates. Downward risks in inflation require a prompt intervention by the fiscal authorities to bolster spending. Authorities should promote demand as much as they can. Unfortunately, both US and European fiscal performances are sluggish. Across economic developments, authorities act reactive rather than proactive. Such an attitude does not promise a V-shaped recovery.


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Tools to sustain financial stability
Macroprudential Policy
Tools to sustain financial stability
Macroprudential Policy
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