Inflation: Not so great expectations

Posted: December 3, 2012 in economy
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THOSE who criticise central banks for having acted with insufficient vigour generally argue that they have failed to talk a good game. Paul Krugman and Michael Woodford are among the best-known advocates of this view. The underlying theory is that the expectation of faster consumer price inflation causes prices to rise more rapidly as people attempt to offset the anticipated erosion of their purchasing power by spending more on goods and services. According to this model, central banks theoretically have the power to lower real borrowing costs and real debt burdens (and real wages) even when nominal interest rates have hit 0%, simply by talking convincingly.The existence of this Jedi mind trick might be desirable given the economy’s weakness. However, it is possible that simply asserting a tolerance for faster inflation over a given period of time or, more radically, altering the inflation target, might actually be counterproductive if the Fed does not—or cannot—generate sufficient increases in wages and prices. If people’s expectations of inflation overshoot what they actually end up enduring, the consequence could be a nasty recession.Until the rich world was hit by “stagflation” in the 1970s, there had been a remarkably stable relationship between the level of joblessness and the speed of price increases. While many economists were befuddled by the apparent …

via Economic Crisis


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