A Little Inflation Can Be a Dangerous Thing

IN all the commentary about Ben S. Bernanke’s recent speech in Jackson Hole, Wyo., little attention has been paid to six crucial words: “in a context of price stability.” Those words concluded a discussion by Mr. Bernanke, the Federal Reserve chairman, of what tools the central bank could consider appropriate to promote a stronger economic recovery.

Ordinarily, a central banker’s affirming the importance of price stability is not headline news. But consider the setting. There is great and understandable disappointment about high unemployment and the absence of a robust economy, and even concern about the possibility of a renewed downturn. There is also a sense of desperation that both monetary and fiscal policy have almost exhausted their potential, given the size of the fiscal deficits and the already extremely low level of interest rates.

So now we are beginning to hear murmurings about the possible invigorating effects of “just a little inflation.” Perhaps 4 or 5 percent a year would be just the thing to deal with the overhang of debt and encourage the “animal spirits” of business, or so the argument goes.

It’s not yet a full-throated chorus. But remarkably, at least one member of the Fed’s policy making committee recently departed from the price-stability script.

The siren song is both alluring and predictable. Economic circumstances and the limitations on orthodox policies are indeed frustrating. After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations — as the Fed and most central banks believe — why not 3 or 4 or even more? Let’s try to get business to jump the gun and invest now in the expectation of higher prices later, and raise housing prices (presumably commodities and gold, too) and maybe wages will follow. If the dollar is weakened, that’s a good thing; it might even help close the trade deficit. And of course, as soon as the economy expands sufficiently, we will promptly return to price stability.

Well, good luck.

Some mathematical models spawned in academic seminars might support this scenario. But all of our economic history says it won’t work that way. I thought we learned that lesson in the 1970s. That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth.

My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate.

It is precisely the common experience with this inflation dynamic that has led central banks around the world to place prime importance on price stability. They do so not at the expense of a strong productive economy. They do it because experience confirms that price stability — and the expectation of that stability — is a key element in keeping interest rates low and sustaining a strong, expanding, fully employed economy.

At a time when foreign countries own trillions of our dollars, when we are dependent on borrowing still more abroad, and when the whole world counts on the dollar’s maintaining its purchasing power, taking on the risks of deliberately promoting inflation would be simply irresponsible.

It is that conviction that underlies Mr. Bernanke’s six words. Let’s not forget them.

President Obama has now set out new proposals to support economic growth. I hope he will be able to work with a responsible Congress to find the common ground that is urgently needed to deal with the economic challenges before us, restoring a healthy economy “in a context of price stability.” I also hope they will reach agreement early next year on a strong program to deal responsibly with our huge budget deficit over the years ahead.

Paul Volcker, a former chairman of the Federal Reserve, is the chairman of the president's Economic Recovery Advisory Board and member of the International Council at the Belfer Center for Science and International Affairs.