Three reasons to cheer inflation

September 23, 2010, 6:36 PM UTC

The Fed says it’s willing to do what it takes to boost the economy, even if that means encouraging inflation. Here’s how that could do the trick.

Higher prices at the grocery store might help.

Paying higher prices for everyday items might not be a welcome development to the millions of cash-strapped and jobless Americans. But as some economists have rightfully argued, a little inflation could actually help stimulate the economy at a time of very slow growth.

True, monetary policies encouraging higher prices aren’t always a good thing. In fact, it often makes people feel poorer as the price of everything from cars to TVs rise. Higher inflation weakens the U.S. dollar, since a buck buys less as prices rise. Also, if you’ve been socking your money away in a bank account, inflation will reduce the value of those savings.

It’s rarely good policy to reward reckless spending at the expense of fiscal discipline. But as James Surowiecki of The New Yorker recently pointed out, inflation has actually helped the U.S. economy in the past. After the Second World War, a period of rising prices helped reduce the national debt to more manageable levels. “Boosting inflation isn’t the right policy, but it may just be the correct one,” he writes.

It appears the U.S. Federal Reserve might agree, if only very subtly. Earlier this week, the Fed said it was prepared to boost inflation if that’s what it will take to “support the economic recovery and to return inflation, over time, to levels consistent with its mandate.” And as Fortune’s Colin Barr points out, the Fed’s message was relatively bold as it was the first time officials explicitly acknowledged that falling inflation could compel them to embark on policies that would put upward pressure on prices.

Here are three reasons why higher inflation, at least in today’s slow growing economy, could give markets a modest jolt:

Softens burden of  debt

Household finances are a mess, which is one of the big factors hampering the pace of economic recovery. Consumers spent too much in the years leading up to the financial crisis and many are now burdened with huge debts. Nearly one in four homeowners owe more on their loans than their homes are worth today. All the while, household net worth has continued to decline, dropping by $1.5 trillion during the second quarter.

With prices rising a little, the value of assets would rise. Wages would also rise, which can make it a little easier for many to pay off their debts. What’s more, because virtually everything else comes with a higher price tag, the value of existing debt appears lower.

Inflation could also soften the burden of national debt, which economists expect to become much more expensive next year, according to a CNNMoney poll. Currently at about 2.75%, the yield on the benchmark 10-year Treasury note is expected to rise to 3.5% with nearly a third of economists expecting it to surge above 4%.

This certainly wouldn’t wipe out debt burdens, but it could at least ease some of the strain.

Stimulates spending

With the personal savings rate unusually high and companies hoarding record levels of cash today, a boost in spending and investment is what the economy needs to start growing faster. And a modest dose of inflation could help set the stage for that.

If consumers expect prices to rise in the future, it’s more likely they’ll spend sooner rather than later because money that just sits in vaults would lose value. In other words, higher inflation would give people less incentive to save.

In the long term, of course, increased savings would help the economy immensely in the long-term. For the short term, however, a boost in spending might just be what the economy needs to accelerate the pace of recovery.

Creates jobs by way of increased spending and investment

One of the leading factors that has kept companies from hiring more is weak consumer demand. If higher inflation stimulates spending, it might just as well give companies the signal they’ve been waiting for to expand and take on more workers.

Admittedly, this might be a bit of a stretch. There are all sorts of economic uncertainties that have kept executives from shoring up headcount, including the anticipated costs of health care legislation reform as well as how much how much income would go toward taxes next year.

A period of higher prices might not be the big fix that this sluggish economy is waiting for. And encouraging higher inflation isn’t always good monetary policy, but when economic times are this tough, it could very well be a prescription to ease some of the pain.

See also:

Don’t blame the consumer

The real fix for the economy: Savings

Death to deficits by ‘a thousand cuts’