The Case Against Inflation

I've always been an adamant inflation hawk, squawking away about the need to reduce the money supply and the fact that the potential for inflation is huge with the fed expanding its balance sheet from 800 billion USD to 2.4 trillion USD is a little over a year.

However, it's sometimes nice to consider the opposite side of the argument, to be the so called "two armed economist." I do, in fact, sometimes bash the fed for keeping interest rates too low for too long. However, after a bit of research, I can see why it has been hesitant to do so.

First is the issue of the Taylor Rule. The Taylor Rule Equation, at its core (without smoothing and error) is:

FF = a (I - I*) + b (Y - Y*)

In plain English, the federal funds rate depends on the inflation gap I (inflation; it is usually symbolized by the Greek letter pi, but I can't type that) minus I* (the inflation target) and the output gap Y (Real GDP) minus Y* (Natural rate of output). If we consider the state of the current economy, we can see that by all calculations, expansionary policy is necessary. Inflation is below the fed's implicit target (around 2%) and output is WAY below its natural rate. In fact, the Taylor rule suggests that the Fed should actually lower interest rates. However, this obviously is not possible with the Fed Funds rate at 0-.25%.

The second telling sign against inflation is the poor capacity utilization numbers right now. Capacity utilization is basically how much of our current resources are being used up. For comparison, think about it like the percentage of rooms that are being used in a school. Usually, US capacity utilization is around 90%, but now, they are a mere 70% (ish). Anyone who studies Keynesian theory knows that in recessions, due to low capacity utilization, the aggregate supply curve is horizontal and will have few upward price pressures even in the case of an increase in demand.

So for these two reasons, I can definitely see the case for dis-inflation. I still think that the risk for inflation is higher and that we're more or less in a liquidity trap at the moment (see: Japan), but then again, I've been wrong before.