Economic Commentary on the Costs of Inflation

Read this article, which discusses how inflation can distort the allocation of resources and adversely affect economic efficiency.


The FOMC has two objectives: maximizing sustainable economic growth, and maintaining price stability. At times - like the past year - these goals appear to be in conflict. This Economic Commentary outlines some economic theory that suggests that in the long run the FOMC can achieve its two objectives by focusing primarily on its price stability target. 

So far this year, the Federal Open Market Committee (FOMC) has lowered the targeted federal funds rate by 275 basis points. Twice, it has reduced the target by 50 basis points following unscheduled meetings. Some commentators have questioned why it took the Committee so long to take these decisive steps. After all, real output growth clearly slowed in the second half of 2000, and inflation measures had apparently ceased the upward trajectory that characterized 1998 and 1999. As late as November of last year, the FOMC had maintained the perspective that the balance of risks in the U.S. economy were weighted in the direction of heightened inflationary pressures, and its public assessment of risks did not shift toward economic weakness until the December meeting. 

There are several potential explanations for the FOMC's behavior. One is that business cycles are characterized by sharp ups and downs in economic activity. Consequently, a fair amount of evidence must accumulate before one can be fairly certain that the economy is entering a period of sustained real-side weakness. (Remember that the so-called softening in the second half of 2000 came on the heels of a remarkably robust first half) 

The Committee must also strike a balance between its - at times - mutually inconsistent goals. While the FOMC is charged with ensuring sustainable economic growth, it is also responsible for maintaining a low-inflation environment. While overall CPI inflation leveled off in 2000–2001, "core" measures of inflation - those that attempt to identify the underlying trend in price growth - have been rising, suggesting that inflationary pressures may be building once again. 

There are, perhaps, important reasons why central bankers only reluctantly shift their focus from inflation to economic growth. It is a widely held belief that, in the long run, the primary channel through which monetary authorities can promote economic growth is by maintaining the purchasing power of the nation's currency. Granted, monetary policy can have positive short-run effects on real economic activity, but such gains would represent a pyrrhic victory if they were purchased at the price of accelerating inflation. 

The economy has likely entered a phase during which attention will, with some justification, shift to concerns over the immediate course of real economic activity. It is also an opportune time to remind ourselves of the costs of inflation - the avoidance of which remains the ultimate long-run goal of monetary policy. 

Source: Paul Gomme,
Public Domain Mark This work is in the Public Domain.