Inflation?

The efficient functioning of a market economy -- the interplay of demand and supply aptly termed the invisible hand by the economist-philosopher Adam Smith back in the 18th century -- depends crucially upon prices serving as accurate signals upon which economic actors such as firms and individuals can base their decisions. Inflation, when prices are changing rapidly due to reasons that have little relationship to economic fundamentals, disrupt the workings of the invisible hand. If individuals and firms do not know what to make of prices in terms of reflecting economic fundamentals then it becomes difficult to make astute economic decisions relating to consumption, saving and investment. Inflation thus has the potential to wreak havoc upon the workings of the economy.

Usually when the economy is on a steady growth path, some amount of inflation is unavoidable. However, what is important in such "normal" times is that the rate of inflation stays low and predictable. As long as individuals and firms know what rate of inflation to expect, and this seems "low," they are able to make decisions and plan ahead. This is why central banks of many countries adopt an explicit "inflation target" (such as say 2%) and make this known to the public. Such an announcement goes hand-in-hand with aggressive tactics such as raising interest rates whenever it seems like inflation is getting close to the upper bound of the target.

At the moment, it doesn't appear that inflation is a concern, given the state of the economy. But it could be, if the economy gathers momentum and the recovery becomes robust. In some sense, though I say this advisedly, this would be a "good" problem to have if it happens in tandem with a faster rate of GDP growth. But tools to combat inflation are severely circumscribed at the moment. Raising interest rates will be quite unpopular, and it is unclear how easy it will be for the Federal Reserve to sell securities and bonds to mop up excess liquidity. And that is the worrisome part.

Inflation-targeting by Central Banks comes with its own set of serious problems (ask Iceland, Brazil, Mexico...).