Does the Economy Need More Inflation?

Despite record-low interest rates, inflation remains a moderate 2.7% over the past twelve months, or 2.3% if you exclude food and energy.

A number of economists have been calling for the Fed to reconsider its 2% inflation target and aim for something closer to 3%-4% in order to reduce unemployment. The Dow (INDEX: ^DJI) may have recovered most of its losses since 2007, but jobs are returning much more slowly.

Generally speaking, there's a trade-off between inflation and economic growth. Moderate inflation can boost the economy, increasing the incentive for consumers and businesses to buy and invest now.

Moderate inflation could also help the recovery by providing some relief to debt-burdened households and businesses. Low inflation may be great for long-term creditors like Bank of America (NYS: BAC) and Annaly Capital (NYS: NLY) , but not so much for debtors -- or their spending power.

In End This Depression Now!, Paul Krugman writes:

According to most economists who have tried to put a number to it, the costs [of 4 percent inflation] would be minor. ... The inflation rate as about 4 percent during Reagan's second term, and that didn't seem especially disruptive at the time. ... If we could manage 4 or 5 percent inflation over [the next five years] ... the real value of mortgage debt would be substantially lower than it looks on current prospect -- and the economy would therefore be substantially further along the road to sustained recovery.

Bernanke, for his part, dismissed the idea that more inflation would be helpful, even though the Fed expects it to come in below its own targets. And Robert Samuelson worries that higher inflation could backfire:

Prices might increase faster than wages, reducing workers' purchasing power and (probably) dampening spending. ... Consumers might become more fearful of the future and, to protect against the unknown, might increase saving and reduce spending. ... Investors -- not knowing whether inflation would return to 2 percent and fearing it might go higher than 4 percent -- might demand much higher interest rates.

Still, at a recent Bloomberg Washington Summit, Robert Engle argued that our economy is paying the price for our anti-inflation zeal:

It seems that we as a global society may need to rethink our hatred of inflation. A little bit of inflation would do a lot of good for economy, housing market, a whole lot of good for Europe. Our notion of what these inflation targets should be should be revised. We haven't had big inflation in decades; I think we've overdone it.

What do you think?

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At the time thisarticle was published Ilan Moscovitz doesn't own shares of any company mentioned. You can follow him on Twitter @TMFDada. The Motley Fool owns shares of Annaly Capital Management and Bank of America. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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