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The Long-run Benefits of Sustained Low Inflation


Richard G. Anderson
Saturday, July 1, 2006

The Federal Open Market Committee (FOMC) tends to tighten monetary policy by increasing real short-term interest rates during economic expansions before incoming data confirm an increase in the rate of inflation. In May, the FOMC increased for the 16th consecutive meeting its target level for the federal funds rate. Today, it seems worthwhile to review the benefits that policymakers believe flow from sustained low inflation.

A common theme among monetary policymakers is that price stability—typically defined as an inflation rate that is sufficiently low, stable and predictable so as not to be a factor in decision-making—is a prerequisite for attaining maximum sustainable economic growth. At the August 2005 Federal Reserve Bank of Kansas City policy conference, then-Fed Chairman Alan Greenspan said, "I presume maximum sustainable economic growth will continue to be our goal, with price stability pursued as a necessary condition to promote that goal." At an October 2004 Federal Reserve Bank of St. Louis conference, Fed Gov. (and soon-to-be Chairman) Ben Bernanke said, "The low-inflation era of the past two decades has seen not only significant improvements in economic growth and productivity but also a marked reduction in economic volatility, both in the United States and abroad. As I have argued elsewhere, there is evidence for the view that improved control of inflation has contributed in important measure to this welcome change in the economy."

Often, policymakers equate low inflation to annual increases of 1 to 2 percent in a broad index of consumer prices, a rate that Chairman Bernanke has dubbed the "Optimal Long-Run Inflation Rate." Such a rate, in part, reflects small measurement biases due to imperfect adjustment for quality changes and the introduction of new goods. The rate also reflects, in part, a cushion against the risk that an adverse economic shock might corner policymakers against the zero lower bound on nominal interest rates.

The costs to the economy of more rapid inflation, measured in foregone real economic output, are primarily of two types. First, "monetary costs" arise as inflation reduces the real return on money, needlessly inducing firms and households to incur additional financial management costs. Inflation also muddies price signals by increasing the difficulty of distinguishing temporary versus permanent changes in the price of goods. Higher inflation also tends to attract real resources, including new college graduates, into professions such as law and financial services that disproportionately benefit by creating anti-inflation hedges and shelters.

Contrary to the protests of policymakers, however, most empirical studies have concluded that the costs of a steady inflation more rapid than the optimal inflation rate are small, often less than three-hundredths of one percentage point of annual GDP growth. But, this opinion is not universally held. Recently, some researchers have challenged this conclusion by arguing that the models omit both the many important difficult-to-measure functions of money and the distortions caused by the nominal nature of the U.S. tax system. These studies suggest that the economy's level of real output may be lower by up to 1 percent for each percentage point that the inflation rate is above that associated with price stability.

In short: Measures of the cost to the economy of sustained inflation above a minimal rate are extremely uncertain. Yet, almost uniformly, central bankers argue that sustained low inflation is a prerequisite to realizing an economy's maximum long-run economic growth. Evidence aside, surveys of inflation expectations suggest that the public is confident the Federal Reserve will sustain an environment of low, stable inflation.