As was widely expected, the Federal Reserve decided to hike interest rates again yesterday afternoon.
It's the fourth hike since the Fed first lifted interest rates off the floor in December 2015. It's the second hike of 2017, and the central bank looks set for one more this year. Each move has been tiny: just 0.25 percentage points, bringing the Fed's new target rate to 1 to 1.25 percentage points.
But despite the modesty of the Fed's course, debate is fierce in economic circles regarding its wisdom. Interest rates are meant to cool off inflation, yet the inflation rate refuses to actually rise to the Fed's 2 percent target. Many of the deeper economic signs that suggest higher inflation is coming are still absent. A whole raft of prominent economists, including former White House advisers, recently called on the Fed to raise its inflation target.
I think the critics are right. At the same time, I realize this sounds counterintuitive: Isn't inflation bad for most Americans? Doesn't inflation mean the incomes of the poor and working class will be worth even less than before? Shouldn't the Fed be extremely averse to any chance of prices rising?
Well, let's start at the beginning.
According to the Fed's own economic models, inflation is driven by wage growth. As the economy improves and more jobs are created, the supply of people out of work gets smaller and smaller. More people with jobs means more consumption, which means more opportunities for businesses to expand and tap new markets. So employers look to hire more. Yet there are also fewer and fewer people without jobs for employers to bring in. Instead, they have to attract people who already have jobs elsewhere.
That usually means offering a better wage. Businesses have to devote more money to compensating their employees, and less to other stuff — like high profit margins, and spitting out lots of dividend payments and share buybacks to their wealthy shareholders. To hang onto profits, businesses may well hike prices. But with labor in scarce supply, workers throughout the economy can just demand another wage hike to compensate for their rising costs of living. A feedback loop sets in across the economy, and you get inflation.
Now, this relationship isn't totally straightforward. Companies might also respond by investing in technology or new business methods and other things that can increase their productivity. This frees up money that can be used to raise wages, so employers don't have to hike prices to hold onto their workers.
So if productivity grows at a steady clip, wages can keep rising without necessarily driving an inflationary spiral. And when there's intense competition for labor, businesses will try hard to increase productivity. Otherwise their higher prices might scare off customers.
The point of all this is that when people think of inflation as destructive, they're thinking of infamous crises like Venezuela or Weimar-era Germany: Inflation shoots up, so every dollar is worth far less. In reality, these sorts of hyperinflationary events are extremely unusual. Inflation and wages almost always rise in tandem; the processes that give rise to both are bound up with one another.
And the benefits of higher inflation for workers don't end there.
Loans are given in a fixed dollar amount — how much you owe a creditor for a mortgage or an auto loan isn't indexed to inflation. So rising inflation actually eases the burden of your debt, because the real value of the fixed dollar amount falls over time, even as your wages rise. Since the vast majority of American workers owe debt to somebody — often quite a bit of debt — higher inflation rates benefit the majority of the populace.
By contrast, persistently low inflation means the real burden of paying off debts remains static or even increases over time. The people who benefit from that are the wealthy Americans and banks who own most everyone's debt. Long periods of low inflation threaten to worsen the inequality gap, and they hold back recoveries: People are spending more of their money paying back creditors, rather than on buying more goods and services.
Finally, when employers are competing for employees, the latter can demand better working conditions. They can fight back against unsafe environments, harassment, and other violations of their rights without fear of unemployment. If their boss does retaliate, they know they'll be able to find another job with ease. Economies where inflation is threatening to rise are economies where workers have more freedom to organize into labor movements, join unions, and more without fear (or at least with much less fear) for their livelihoods.
Now, it's possible for inflation to rise without a corresponding rise in wages: The government can screw up how it calculates prices, which can then feed into wages in employment contracts. (Though contracts that index pay to inflation are far more rare today.) Or it can screw up international exchange rates, which is what happened in Venezuela. (Though that's a much bigger problem for countries that, unlike America, rely heavily on foreign currencies.) And occasionally we'll get some sort of price shock to a ubiquitous and basic commodity, like oil, that can spread to prices throughout the rest of the economy. The Weimar inflation was brought on by the catastrophic aftermath of World War I. In other words, these were fluke events; the exceptions to the rule.
In general, when prices are continuously pressing upward, wages are continuously pressing upwards, too. That drives competition between companies and forces improvements in productivity. Everyone has money to spend, fueling job creation. Recoveries from recessions are swift and robust, driven by that underlying power. Workers can demand a better deal, and employers usually have to give it to them.
Low inflation may seem intuitively desirable. But wishing for low inflation is effectively wishing for all of that to go away.
In the last few decades, economic policymakers got that wish. Inflation was successfully brought down to 2 percent and stabilized there, in what's been termed the "great moderation." But it's also been an era of rising inequality, stagnating wages, rising household debt, and jobless recoveries. And now the Fed finds itself trying to coax more growth out of an American economy that's basically stuck.
In other words, be careful what you wish for.