With inflation in the United States and elsewhere low by historical standards, the question of what inflation rate policymakers should aim for has moved front and center. Knowing what inflation rate to aim for is critically important for maximizing the economic well-being of the public.

Most policymakers agree they should not allow inflation to fall below zero because the costs of deflation are thought to be high. They disagree, however, about how much above zero, if any, central banks should aim to keep inflation. Unfortunately, rigorous estimates of an "optimal inflation rate" have not been available in the economics literature.

Billi and Kahn provide estimates of the optimal inflation rate. Based on a standard, modern macroeconomic model calibrated to U.S. data, they estimate the optimal inflation rate to be 0.7 to 1.4 percent per year as measured by the PCE price index. This estimate is the first to be based on an economic model in which policymakers are assumed explicitly to maximize the economic well-being of the public. Further research is required to confirm or refine these results using models that incorporate a richer array of possible interactions between the long-run inflation objective and economic stability.

Understanding the Effects of the Merger Boom on Community Banks (PDF 447K)
By Julapa Jagtiani

The merger boom in the U.S. banking industry has caused the number of banking organizations in the nation to fall by nearly a third since 1990. Most of this contraction has involved small community banks.

A common perception is that most of these small banks are being absorbed by large banks. The disappearance of small banks is raising concerns in many communities because small banks are often a major source of personal services and relationship lending to local businesses and depositors.

Jagtiani investigates the merger boom in detail and suggests that the merger boom actually has the potential to strengthen the community banking sector, as some community banks are taken over by other, more efficiently run community banks located in the same state. Thus, the community banks that have survived the merger boom may be in a good position to continue serving the local businesses and depositors who value personal service and relationship lending.

How Is the Rise in National Defense Spending Affecting the Tenth District Economy? (PDF 1,114K)
By Chad R. Wilkerson and Megan D. Williams

In 2007, the United States spent over $650 billion on national defense. Even after adjusting for inflation, this was the largest annual amount since 1945, surpassing previous post-World War II peaks reached during the Korean, Vietnam, and Cold wars. Defense spending has risen steadily this decade, today accounting for nearly 5 percent of overall gross domestic product—about the same share as residential construction.

National defense represents an even larger share of economic activity in the Tenth Federal Reserve District. The region is home to some of the country's largest military installations, a number of private defense contractors, and a disproportionately large number of reservists and National Guardsmen.

Is the buildup in national defense stimulating the economies of the states in the Tenth District? Wilkerson and Williams find that, relative to the nation, increased defense spending is likely to help the region more in the long run than the short run. Since 2001, defense spending has risen more moderately in the district than the nation, due primarily to slower growth in the types of defense activities concentrated in the region. Still, the region is poised for an expansion of defense spending in the future. And the region benefits from a less cyclical defense sector than that of the nation.

Will Farmland Values Keep Booming? (PDF 1,227K)
By Jason Henderson

Lean supplies, strong export activity, and vibrant demand both at home and abroad have pushed crop prices to record highs, offsetting today’s spiraling production costs. As a result, farm profits and investments have soared, and farmland values have boomed.

But commodity markets in agriculture can change directions abruptly—and so agricultural bankers and farm analysts naturally question the sustainability of today’s prosperity. The current agriculture boom is strikingly similar to those of the 1970s and mid-1990s, when the good times quickly faded as crop supplies increased, the dollar strengthened, and export activity weakened. One particular danger is that rising farmland values could be accompanied by greater financial leverage, increasing the industry’s vulnerability to a drop in income, as in the 1980s.

Henderson discusses current farmland value trends and analyzes the factors underlying the recent surge. He concludes that the recent surge in farmland values tracks expected gains in crop returns. At the same time, however, an unexpected surge in production costs or a drop in crop prices could undercut farmland values and pose a financial risk to the farm sector. Thus far, however, the industry’s debt levels are up only modestly, helping to mitigate the risks of a drop in farm incomes.