Tuesday, 17 February 2009

Schizophrenic inflation forecasts

Stephanie Flanders expresses an opinion which seems to reflect the conversation throughout most economics blogs, as well as - she suggests - in the City. That is, we are either due for severe deflation or high inflation - nothing in between.

Interestingly, the deflation story mainly comes from the authors of the blogs, while the runaway inflation opinion is mostly in the comments. You might say that shows which opinion reflects economic orthodoxy, but not necessarily which one is more likely to be accurate.

The most likely scenario may in fact be "both" rather than "either". Deflation in the short term, which we hope will be arrested by the immense monetary and slightly-less-immense fiscal stimuli coming out of most rich-country governments. Followed by inflation in a couple of years, which central banks will try to contain by mopping up excess money supply - with no consensus on their likelihood of success.

Most economists would say that the inflation is a price worth paying for avoiding a depression. Inflation does impose a deadweight cost because it makes prices harder to predict and compare, and distorts purchasing and investment decisions accordingly. But assuming we don't get hyperinflation (which is still extremely unlikely) this cost is probably less than the damage that would be done by a severe reduction in output.

On this blog I am interested in perceptions, knowledge and behaviour. What is the impact of inflation on these factors - or of these factors on inflation?

Hyperbolic discounting is one filter through which we can consider these effects. This means that people apply a higher discount to near-future deferral of income than far-future. The classic example is that if I offer you £100 now or £120 in a year, you'll probably take £100 now. But if I offer you £100 in a year or £120 in two years, you'll probably take £120 in two years. So you apply a discount rate of more than 20% now, and less than 20% in a year's time.

In principle this might reflect an expectation that inflation will be lower in a year than it is now, but the result seems to appear in experiments over time regardless of inflation levels.

In a world where we expect deflation today and high inflation in a couple of years, our money should be worth more in a year and less in three. This has problematic effects on both consumption and investment. Hyperbolic discounting could perhaps counter this.

I am a firm believer that government should use behavioural research just as much as classical economic theory when setting policy. Thus, by offering consumers a one-year advance on monetary transfers such as tax credits or benefits - or equivalently a deferral of tax payments - government can take advantage of its ability to borrow short-term at low cost (reinforced by expected deflation), and boost current spending without substantial impact on deficits. The repayments may need to be spread over a longer period to avoid a demand crunch in a year's time, but that is easily affordable in the context of current government borrowing.

So an additional fiscal boost now, financed by pre-announced tax increases in 3-5 years, should both have an oversized impact on current spending and a damping effect on expected medium-term inflation. Sounds like it's worth a try.

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