It's Time to Start Hoping for More Inflation

More inflation may be just what the economy needs to get out of its current rut.

John Guy inspects a sheet of money during the phase of production of the new $100 bills at the U.S. Bureau of Engraving and Printing's Western Currency Facility Oct. 11, 2013 in Fort Worth, Texas.

The Federal Reserve believes more inflation could give lackluster economic growth a needed boost.

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After years of printing money, the Federal Reserve is growing more concerned about inflation.

No, not that prices are spiraling out of control. That fear is out there, of course, and opponents of the Fed's quantitative easing have voiced their inflation concerns since the program started.

Instead, the latest statements from the Federal Open Market Committee, the Fed committee tasked with setting interest rate policy, show the Fed is keeping its eye on whether inflation is getting too low.

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Fed statements tend to maintain some continuity from meeting to meeting – after each FOMC meeting analysts pore over wording changes – but in its last few meetings, the committee added new language to statements saying that lower inflation could hurt economic growth.

"The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance," they wrote.

What the Committee is saying is that more inflation could be key to boosting lackluster economic growth. Higher prices can boost the economy, and vice versa.

"One generates the other and the other generates the first one. There's a few back mechanisms in there," says Gregory Daco, senior U.S. economist at Oxford Economics.

Consider a city with a lot of renters. Apartment owners may see some young and relatively high income people move into the city and decide they can charge more for rent. If that happens on a broad enough scale, more employers may feel the need to raise their wages in order to attract workers. Ideally, that raise leaves workers with some leftover money to spend or save elsewhere, making them richer in real terms. And the money from higher rents, meanwhile, could lead rental companies to hire more workers or boost pay to their workers, which could also be an economic boost.

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That's a simplified scenario, but it's one illustration of how inflation boosts growth. Not that there can't be too much of a good thing. Anyone who lived through the double-digit inflation of the late 1970s and early 1980s can well remember how too much inflation can be bad for the economy. Fast-climbing prices saw Americans lose purchasing power with their dollars and families pulled back on their spending.

The key is wage inflation keeping up with price inflation, says Daco.

"Whenever I talk about inflation, I tend to look at wage inflation because that's sort of the key element here," he says. "If you don't have wage inflation, you're really not going to have much impetus for price inflation domestically."

Currently, inflation is running at around 1.2 to 1.3 percent, depending on which measure one looks at – nowhere near the runaway levels of three decades ago. It's also below the 2.5 percent threshold the Fed has said would likely trigger it to raise interest rates from their current near-zero level.

While the Fed has been pumping money into the economy, a move that under normal circumstances might inspire inflation, what central bankers may fear most right now is deflation, says one expert.

"What they're concerned about is does this eventually lead into a deflation type of scenario?" says Scott McGough, director of fixed income management at investment management firm Glenmede. "Which is not a good scenario because at this point with all the extra tools that they've taken out of the toolbox, there's not much left that they can do.

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One of the many problems with deflation is that it can lead to higher unemployment, says Daco, because wages don't grow and shrink the way prices do. Employers tend to be more ready to pull back on hiring and to fire workers than to cut pay, he says. Furthermore, falling prices make people less willing to spend, as they wait for prices to fall even lower, slowing the economy even further.

However, says McGough, it may not be that the Fed is worried so much as it is justifying its actions in keeping QE3 going a little longer. Indeed, the Fed has said it sees inflation moving back towards its target over the longer run.