John Cochrane on Inflation

John Cochrane’s op-ed in the WSJ, with a link here to the WSJ original and a link here to his blog, The Grumpy Economist.

First, I confess I am not a macro-economist (worse yet, I confess that the training I received in macro-economics was rather basic).  The conversation around inflation has baffled me for some time, and I think there are two primary drivers of “stable inflation policy” (which Cochrane addresses in his article): 1) government’s debt levels are at all time highs, and 2) inflation provides “wiggle” room to central banks to achieve economic growth targets.  Inflation touches the rest of us as individuals in one way of which I can think: it devalues our cash and encourages the purchase of goods or assets.  You may say: “it also gives us raises or pushes up the value of assets over time (like our houses).”  Not really – if inflation is 2 percent and your wage increase is 2 percent, then you didn’t really get a raise; and raises above inflation are tied to increases in productivity.  As far as asset pricing: inflation impacts our purchase behavior regarding assets (think of gold), and thus our expectations of inflation may drive asset pricing – BUT, most asset values are driven primarily by market behavior, government policy, demand, etc… When mortgage rates hit all time lows (as they have in recent years) then mortgages become less expensive, demand for them increases, and their complimentary good, real estate, experiences increased demand, thus driving up prices.  Expectations of inflation are also priced into the asset by the market.  So for individual purchasers, we may be relatively indifferent about low levels of inflation or deflation over the long-run.  Now I expect you to ask: “What about mortgages and long-term deflation?”  You’re very smart.  I can see where 1 or 2 percent deflation over 30 years would create challenges for fixed debt payments over such an extended time.  I can only assume that absent confounding policies (politics), that markets would price that expectation into the purchase price – but as most assets were purchased previously in periods of expected inflation, it could cause some interesting market frictions… maybe.  The truth is: I don’t know.

I find the debate interesting, but frequently populated by contradictions or hidden motivations (governments have a very clear incentive to create inflation).  The truth is, given our recent experience in the US and Europe and two decades of low-rates in Japan, it doesn’t appear that anyone knows what drives inflation in advanced and complicated economies.