In 1996, Federal Reserve Chairman Alan Greenspan had an exchange with Janet Yellen, then a member of the Fed’s Board of Governors, that presaged a major – and, I think, ill-advised – change in the central bank’s approach to managing the economy.
Yellen asked Greenspan: “How do you define price stability?” He gave what I see as the only sensible answer: “That state in which expected changes in the general price level do not effectively alter business or household decisions.” Yellen persisted: “Could you please put a number on that?”
Since then, under the chairmanship of Ben Bernanke and then under Yellen, Alan’s general principle – to me entirely appropriate – has been translated into a number: 2 percent. And more recently, a remarkable consensus has developed among central bankers that there’s a new “red line” for policy: A 2 percent rate of increase in some carefully designed consumer price index is acceptable, even desirable, and at the same time provides a limit.
Yet, as I write, with economic growth rising and the unemployment rate near historic lows, concerns are being voiced that consumer prices are growing too slowly – just because they’re a quarter percent or so below the 2 percent target!
I understand reasonable arguments can be made for 2 percent as an upper limit for “stability.”
Perhaps an increase to 3 percent to provide a slight stimulus if the economy seems too sluggish? And, if 3 percent isn’t enough, why not 4 percent?
The fact is, even if it would be desirable, the tools of monetary and fiscal policy simply don’t permit that degree of precision.
The old belief that a little inflation is a good thing for employment, preached long ago by some of my own Harvard professors, lingers on even though Nobel Prize–winning research and experience suggests otherwise. In its new, more sophisticated form it seems to be fear of deflation that drives the argument.
Deflation, defined as a significant decline in prices, is indeed a serious matter if extended over time. It has not been a reality in this country for more than 80 years.
Still, the argument runs, let’s keep “a little inflation” – even in a recession. Yet the argument seems to me to have little empirical support even as fear of deflation seems to have become common among officials and commentators alike. In point of fact, actual deflation is rare.
History tells the story. In the United States, we have had decades of good growth without inflation – in the 1950s and early 1960s, and again in the 1990s through the early 2000s. Those years of stability were also marked by eight recessions, mostly quick, that posed no risk of deflation.
Only once in the past century, in the 1930s, have we had deflation, serious deflation. In 2008–2009 there was cause for concern. The common characteristic of those two incidents was collapse of the financial system.
The lesson then, to me, is crystal clear. Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk.
The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the “easy money,” striving for a “little inflation” as a means of forestalling deflation, could, in the end, be what brings it about.
Paul Volcker served as chairman of the Federal Reserve from 1979-87. This edited excerpt from the upcoming book “Keeping At It: The Quest for Sound Money and Good Government,” by Paul Volcker with Christine Harper, appeared in Bloomberg Opinion.