Posted Thursday, May 3, 2012, at 5:32 PM
To most people the idea that more inflation might help boost real growth sounds both confusing and confused. I think the point can be made more clearly by saying that what's needed is to be tolerant of inflation rather than eager to see it per se.
To see why, first recall that at this point the recession as such has been over for a long time. Quarter after quarter, the U.S. economy grows a bit. It hasn't even been particularly sluggish growth. It just hasn't been the kind of super-fast "catch-up" growth that produces large reductions in unemployment. That, however, is the kind of growth we'd like to see. So now imagine some Good News strikes the American economy. Maybe all over the world, vacationing in the United States suddenly becomes fashionable and everyone starts booking their tickets. Why is that good news? Well it's good news because hotels and restaurants are going to need to hire a bunch of extra workers to meet that surging demand for their services. What's more, ancillary economic activity in transporting stuff to the hotels and restaurants will go up. Firms may need some new equipment along with the new workers boosting manufacturing. And since lots of these new workers will have been living at their parents or siblings house while they were jobless, they're suddenly going to sally forth and get places of their own. That's going to lead to new purchases of small appliances and furniture (more manufacturing jobs) plus various ancillary services associated with shipping and delivery. All-in-all, the tourist surge should help set off a fairly broad-based boom—so broad-based that lots of people won't even realize that the tourism surge has anything to do with it.
But there's a problem here. The surge of tourist bookings is going to send airfares up. It's going to send hotel rates up. All the new people getting jobs and commuting to work is going to push gasoline prices up. Rents will stay high until new homes can be built. Some restaurants are struggling today and will simply fill up as a result of the influx of customers, but some restaurants are already full and thriving and will just raise prices. If that inflation prompts the Federal Reserve to promptly raise interest rates, then instead of a broad-based boom we're going to see a kind of awkward hiccup and the economy will re-settle at a depressed level. Possibly not in the exact same configuration—some different specific individuals will end up unemployed—but not at any radically new equilibrium. To break through to the new equilibrium you have to be willing to say, "hey I know the higher rent and gas prices are annoying, but these are side-effects of the incipient boom we need."