15 October 2010

Inflation Low

Conventional wisdom in policy circles is that high inflation is bad, and deflation is worse. By that standard, our monetary policy couldn't be better. Inflation, as measured by the consumer price index over the last twelve months, is 1.1%. Core inflation, which excludes the volatile food and energy sectors has been 0.8% over the last twelve months. The are other ways to measure it, but the result is always the same. September's results were right on the trendline:

the seasonally adjusted CPI for all urban consumers rose 0.1% (1.2% annualized rate) in September. The CPI less food and energy was unchanged at 0.0% (0.0% annualized rate) on a seasonally adjusted basis.

We are not in a period of deflation, but inflation rates are very low by historic standards. Other than a very brief episode of deflation in the mid-1950s, that followed and was followed by inflation spikes, you have to go back to the 1920s and the Great Depression to see inflation so low.

We also continue to have record low interest rates for safe investments like Treasuries, the prime rate, and prime mortgages, in part because inflation rates and expectations of future inflation, are so low.

Yet, there are reasons to wonder if the whole story is told by CPI. Gold prices are near record highs, and the U.S. currency is not particularly strong in the foreign exchange markets, both of which would typically be signs of strong inflationary expectations.

Inflation is also not a distributionally neutral matter, because most debts in the United States, and a very large share of income investments, are denominated in nominal dollar terms without explicit inflation adjustments.

Low inflation rates or deflation favors creditors. High inflation rates favor debtors. This is unequivocally true for fixed rate unsecured loans. But, for secured lending, like mortgages and car loans, harm to creditors is partially mitigated by the increases in the value of the collateral that flow from inflation that make default related losses less likely, and with variable rate loans, creditors can benefit from increased interest rates duruing inflationary times that compensate for the declining value of the principal amount due on a loan. Inflation also hurts people who live on fixed income investments like bond portfolios, because prices rise while their incomes do not.

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