Buzz Off Inflation Hawks, We Need Higher Prices

A little digging into the St. Louis Federal Reserve database reveals that the US economy has been charting a textbook course along the Phillips Curve over the past few years.  As the chart shows, the trade off between unemployment and inflation is this: Inflation rises (wages and prices go UP), this results in a more robust economy where people (excited by the higher wages, or astounded by the higher prices) find jobs with more vigor, thus unemployment falls!

As you can see, 2010-2012 has seen two separate ticks up in the inflation rate (as measured by the year/year rate of change in core CPI) which have been followed like clockwork by a decrease in the unemployment rate - small decrease you say? Remember that each percentage point on the unemployment scale includes millions of people, so not a trivial amount by any means.  In fact, unemployment is currently at the lowest levels it's been since the 2008 financial crisis!

Simple as it may be, I'd say this one chart is proof that the macroeconomy is indeed on the path to recovery. However, danger is afoot:

The International Monetary Fund recently reported that the Euro zone is in danger of slipping again into a period of deflation.  This could send another shock wave through the world financial markets as falling asset prices (stocks, and homes) translate into falling wages and deeper global recession.

As anyone who knows much about monetary policy will tell you, deflation is worse than inflation almost any day of the week.  Simply because not only does it take the wind out of the sails of the economy, it slices off huge portions of household net worth in the form of falling home prices and shrinking retirement accounts.

Bottom line: the US has just endured a bout of deflation, and it should be in no mood to try another one.  Federal Reserve chairman Ben Bernanke said yesterday that the Fed would not consider further stimulus if the inflation rate did not fall below 2%.  Considering the notable lag time that you must account for in monetary policy, maybe he should consider a 3% target...