What’s Holding Back Inflation?


The labor market is tightening. Wages are rising. And yet, despite very aggressive monetary policy efforts, United States central bankers have been unable to hit their inflation target. For more than 4 straight years, the Federal Reserve’s preferred measure of inflation has been below its target of 2%.  This has happened despite an explosion of assets on the balance sheet of the Federal Reserve, which rose from 6 percent of GDP to 24 percent between 2008 and 2016.

And it’s not just here in the US that prices are stubbornly refusing to rise. They’ve been treading water across many of the world’s major economies, including in the Eurozone and Japan. The ECB has been missing its mark for over three years, and the Bank of Japan, which has been fighting deflation for 15 years, has similarly struggled to increase prices.  Meanwhile, between 2008 and 2016, the ratio of central bank assets to GDP hasgrown from 22 percent to 90 percent in Japan, and from 14 percent to 35 percent in the Eurozone.

Under conventional wisdom, quantitative easing and other unconventional policies should have produced extraordinary inflation, quite possibly even hyperinflation. So what the heck is going on? Three important trends are drowning the global economy in deflationary waves, thwarting the best efforts of central bankers: (1) the slowdown in China, (2) a technology- and globalization-driven decline in manufacturing costs, and (3) aging populations in the developed world.

Under conventional wisdom, quantitative easing and other unconventional policies should have produced extraordinary inflation, quite possibly even hyperinflation.

China’s transition from investment-led to consumption-led growth has not been smooth. It’s exposed massive overcapacity that the country built up in industrial sectors like steel, cement, and aluminum, and significant over-investment by global mining companies. As demand growth has slowed, prices have fallen across the board. Since June 2011, the price of iron ore has dropped nearly 70 percent, and the prices of copper and crude oil have fallen by half.

In response to the sputtering economy, Chinese policymakers have focused on pump-priming the country’s export engine. Specifically, they have been devaluing the currency to increase the competitiveness of Chinese goods in global markets.  Since last August, the yuan has dropped 7 percent against the dollar.  By devaluing their currency, China is importing inflation via higher prices for imported goods. The flip side of this dynamic is that Chinese goods are cheaper to foreign consumers. Let’s not fool ourselves, China is exporting deflation.

A related issue is the declining cost of manufactured goods thanks to technological progress and globalization.  According to the Financial Times’Matthew Klein, 88 percent of US inflation since 1990 has come from healthcare, prescription drugs, housing, and education.  Meanwhile, Klein points out, the prices of high-tech goods like televisions and computers have fallen at a rate of 12 and 18 percent per year, respectively, while the cost of low-tech goods like luggage and linens has also dropped dramatically.

The Millennial generation, which has never experienced broad inflation, now expects regularly declining prices for consumer goods.  This may be one reason why their inflation expectations are consistently lower than those of older people. And as the ranks of Millennials overtake those of other generations, these dynamics will be increasingly problematic for the Fed, which is trying to get the population to expect regularly and modestly rising prices.

Another potential long-term driver of deflationary pressure is demographics.  As Breughel’s Jérémie Cohen-Stetton summarizes, in the last decade, population growth rates were positively correlated with inflation rates, and there are some reasons to believe this is more than just a coincidence.  For instance, aging populations in the developed world may lower growth expectations and investment, thereby depressing demand.  Or they may give policymakers political incentives to keep inflation low in order to protect the purchasing power of those on fixed incomes. Take Japan, a society that is rapidly aging. Might it be that the population actually wants deflation?

Aging populations in the developed world may lower growth expectations and investment, thereby depressing demand.

At the same time that the developed world is aging, the population of the emerging world is exploding. But because the purchasing power of these individuals is meaningfully lower than those of developed world consumers, the impact on demand is not nearly large enough to offset the impact of the aging developed world.

The persistence of low or negative inflation can become a self-fulfilling prophecy.  As central banks consistently miss their stated targets, they lose credibility, making it likelier that they will miss their targets in the future.  Bank of Japan governor Haruhiko Kuroda recently compared this dynamic to the story of Peter Pan: “the moment you doubt whether you can fly, you cease forever to be able to do it.”

While deflationary pressures run rampant, recent data suggest the possibility of rising prices. This month’s census report showed a tight labor market drove a 5.2% real increase in the median household income last year. According to Goldman Sachs, wage growth is now running at an annual rate of 2.6 percent. Analysts like Goldman Sachs economist Daan Struyven have argued that we are underestimating how quickly the tighter labor market could speed along the Fed’s meeting—or overshooting—its target.  If we do see a wage-price spiral take hold, American Millennials may get the first dose of rapid inflation in their lifetimes.

Suffering a trend like missed inflation targets for so long, there is always the risk we’ll grow complacent and pay dearly for a rapid reversal. With all eyes on the prize of 2%, we must be careful we don’t overshoot dramatically.

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