Binyamin Appelbaum had an interesting discussion of inflation in the NYT yesterday. As he notes, it has been below the Fed’s target throughout the recovery and, contrary to expectations, it has been falling in recent months. This suggests that the economy could be operating at a higher level of output with more employment. That would put more upward pressure on wages and lead to somewhat higher inflation. That suggests that the Fed may have been wrong in its recent interest rates hikes which were intended to slow growth.
There are a few other points worth noting about inflation while we are on the topic. While it is common to say that inflation hurts investment, at least in the U.S. this does not appear to have been the case.
As can be seen, the investment share of GDP peaked in the late 1970s and early 1980s when inflation was also running at its most rapid pace in the post-World War II era. Investment has been considerably lower as a share of GDP in the last three decades of moderate inflation. The one exception when investment got close to its peak of the high inflation era was at the end of the 1990s during the stock bubble.
While it would probably be wrong to say that the high inflation of the late 1970s and early 1980s was the cause of high investment, it seems difficult to make the case that it was a serious impediment to investment. It is also worth noting that we saw inflation that crossed into the double-digits in those years. If that pace of inflation didn’t slow investment, it is difficult to believe that a modest increase in the inflation rate in the current period, say to 3 or 4 percent, could have a negative impact on investment.
One reason inflation accelerated quickly in that era was that the Consumer Price Index (CPI) had an error in housing component that caused it to overstate the annual rate of inflation by as much as 2.0 percentage points. At a time when many contracts were indexed to the CPI this error in measurement was passed on in the form of higher wages, rents, and other prices.
