I had an interesting conversation with my wife this morning. She says: "Walmart has increased prices on everything!" In the back of my mind I remember a recent post by Noah Smith on inflation, so I say: "That's great - it will make central bankers very happy. They've been worried sick inflation is too low and economy is not performing well making us all poorer." She says: "How come, this is crazy! Most people who shop at Walmart cannot afford higher prices. Inflation clearly makes them poorer and will actually cause them to consume less. Doesn't this hurt the economy?"
Here I begin to struggle. How do you explain to a non-economist why central banks like low inflation? "You see sometimes the economy goes into a downturn, which we call a recession. Businesses close and people lose their jobs making society poorer. In response, Central Banks will usually lower interest rates. This spurs desire for borrowing and spending which gets the economy going again. It's like an engine. When it begins to sputter, central banks put more fuel. Now, sometimes the downturn is so severe that interest rates reach zero, and central banks can no longer jump start the economy by lowering rates. People cut spending and hoard cash for a rainy day, which leaves the economy operating below capacity with many unemployed. That's why central banks always like to pump enough fuel into the engine, so it keeps making a low humming sound. Such low inflation, arguably around 2%, acts as a cushion against the dreaded lower zero bound."
My wife was quick to respond. "So do you know why the engine sputtered in the first place? Why did the economy go into a downturn?" I smile: "Well that's complicated. There are many competing theories that attempt to explain the business cycle, but we don't need to get into that right now. The important thing is that low levels of inflation indicate an economy operating at capacity and preserve the central bank' ability to jump start the economic engine when it does go into a downturn."
"What you are saying is that the economy is like an engine. When it works well it makes a nice purring sound. When it stops working, rather than finding and fixing the core issue, policy makers focus on fixing the sound. Even more importantly, this artificial hum makes the engine work better for some at the expense of others?"
At this point, I had to concede and agree that we need a new paradigm.