A New Price Index Might Be of Use

"Embracing Inflation" (Kenneth Rogoff)

It is time for the world's major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today's epic debt morass...

Modern finance has succeeded in creating a default dynamic of such stupefying complexity that it defies standard approaches to debt workouts. Securitisation, structured finance and other innovations have so interwoven the financial system's various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed.

Moderate inflation in the short run – say, 6% for two years – would not clear the books. But it would significantly ameliorate the problems, making other steps less costly and more effective.

True, once the inflation genie is let out of the bottle, it could take several years to put it back in. No one wants to relive the anti-inflation fights of the 1980s and 1990s. But right now, the global economy is teetering on the precipice of disaster. We already have a full-blown global recession. Unless governments get ahead of the problem, we risk a severe worldwide downturn unlike anything we have seen since the 1930s...

Fortunately, creating inflation is not rocket science. All central banks need to do is to keep printing money to buy up government debt. The main risk is that inflation could overshoot, landing at 20% or 30% instead of 5-6%. Indeed, fear of overshooting paralysed the Bank of Japan for a decade. But this problem is easily negotiated. With good communication policy, inflation expectations can be contained, and inflation can be brought down as quickly as necessary.

It will take every tool in the box to fix today's once-in-a-century financial crisis. Fear of inflation, when viewed in the context of a possible global depression, is like worrying about getting the measles when one is in danger of getting the plague.

Good to hear this from a top policy economist like Rogoff (Harvard, former chief economist at the IMF); I thought I must be missing something.  Yes, some inflation right now would be a good idea.  To keep inflation from getting out of hand, this might be a clever trick.  Develop and publish retrospectively an alternative price index, which includes (a) housing, (b) stocks and other assets, and (c) foreign currency.  What I expect we'll see is:

• In the Greenspan years and up until about end-2006, inflation by this measure will have been a lot more than the traditional CPI would measure.
• In the past two years, we'll have had deflation by this measure, well before it hit consumer prices, due to falling housing prices and stocks (and until the past few months, a weakening dollar).  

What this would suggest is that the Fed should try to push prices back up to their levels in 2006.  That doesn't mean housing prices would have to go back, or stocks; rather, the overall price index should recover its value, but if there's been a shift in relative prices, if houses stay less, then consumer prices might have to be higher than in 2006 for overall prices to regain that level.  At the same time, the new price index will not signal higher long-run inflation.  On the contrary, they'll signal that the Fed will not allow asset bubbles to inflate in the future, and that if there is renewed upward pressure on real estate and stock prices, or a steep decline in the dollar, the Fed will force consumer prices down to offset it.