There is a nice little post at VoxEU, “(At least) Three simple reasons to fear inflation,” by Tommaso Monacelli, Associate Professor of Economics at Università Bocconi, Milan.
While the entire article is worth reading, I thought his discussion of the interaction between growth and inflation was particulalry useful:
In the plethora of comments on the effects of the current financial/credit shock, there seems to be a bit of confusion on its likely inflationary consequences. For instance, a commonly heard criticism to the ECB runs as follows: why worry so much about inflation? If indeed we are entering a recession, it will be the economic slowdown as such to ensure that inflationary pressures remain contained. Hence it would be preferable to do as much as possible to support the already weak growth in Europe. Seen from a different perspective: the financial shock we are facing is intrinsically deflationary.
This argument may prove fallacious, for at least two reasons. The first is well-known: not accepting a moderate slowdown today may induce an inflationary spiral that will require a radical change of direction of monetary policy in the future, with potentially very painful consequences for the real economy. To understand the second argument, it is necessary to recall the Phillips curve. According to this concept, current inflation depends on: (i) inflation expectations for the future; and (ii) the deviation of output from its potential level, i.e., the output gap. What is potential output? It is the level of output that an economy can achieve when prices and wages adjust in a perfectly flexible way to clear markets. Essentially, it is the level of output at which an economy tends to be on average. Potential output, however, is not immutable. It responds to structural changes in the degree of competitiveness of goods, labour and financial markets.
Both in the US and in the Euro Area, however, it is not yet clear whether the type of financial shock we are currently facing will ultimately have a negative impact on potential, rather than cyclical, output. In other words, it is uncertain whether this is a shock that may affect the degree of efficiency of our financial markets. If that were the case, that same shock may produce an upward, rather downward, pressure on the output gap. We would then be faced with an inflationary, rather than a deflationary shock, with the implication that this would require interest rates to rise rather than fall. Are European governments prepared for such a contractionary policy scenario?
It is instructive to recall the lesson of the 1970s. Then the fall in potential output was due to a slowdown in the rate of growth of productivity, which central banks largely failed to identify, leading to sometimes completely erroneous measurements of the level of potential output, and subsequently the effects of its changes on inflation. Today we may find ourselves once again faced with a similar problem, let alone the contemporaneous materializing, as then, of an oil shock. Yet another reason to avoid any complacency about inflation.