What do central banks think about the current level of inflation?
"The mystery of inflation" is the new dilemma afflicting economists and investors. As the economy grows and – like in America – runs at full capacity, inflation should perk up; instead, it remains at unusually low levels. Understanding why this is happening is crucial for central bankers for determining their next steps, and for investors confused about the current actual state of the economy.
In this context, it is worth briefly reminding some concepts of the economic theory considered by central banks, in order to check if they can still be useful in explaining the current odd situation. Regarding this topic, the most known tool is the famous Phillips curve, which states that there is a trade-off between inflation and unemployment: central banks can spur the economic growth only at the cost of accepting more inflation. However, this relationship holds just in the short term. Indeed, monetary policy cannot affect the real factors in the long run (it cannot sustain the economic growth forever), thus an overly prolonged monetary stimulus will ultimately result exclusively in higher inflation: economists are used to refer to this concept as "vertical long-run Phillips curve". Lastly, while in the long period inflation is only a monetary phenomenon, in the short term it can be affected by real factors as well.
Looking at the current situation, the absence of inflation – even in presence of growing economies – can be explained by a number of elements outside the control of central banks. Low commodity prices, globalisation, technological advances and weaker unions are depressing overall prices. In other words, inflation is kept at low levels precisely by real factors.
At the same time, interest rates are at historic lows too. The first reason is certainly the behaviour of central banks. They have been keeping short term interest rates low for a long time, which in turn makes long term interest rates lower as well; moreover, they launched QE programmes aiming at lowering directly long term rates. However, there are also structural changes in the economy that have contributed to this situation. On one side, the supply of savings has risen, mainly because of ageing population (workers at the end of their career tend to save more) and the high propensity to save of the Chinese people (who dramatically increased their wealth in the last decades). On the other side, the demand for investment has fallen, as the economy has shifted toward the technology industry, which is less capital intensive than the traditional ones. Obviously, more savings and less investments pushed down interest rates.
Given the current situation, one reasonable thinking could be that, if inflation doesn’t accelerate even in presence of exceptionally loose monetary policies, this means that the structural forces keeping interest rates low are indeed prevailing. In other words, the natural interest rate should now be around zero. The implication is that the rates set by central banks are not actually so accommodating, but almost in line with the neutral rate.
Yet other arguments should be taken into account. As said, inflation is currently low because of real factors and, in theory, such forces should just be temporary. Indeed, it is important to keep in mind that inflation is about price variations and not price levels. For example, as commodity prices stabilize at lower level, their new variations might well be positive – as it is actually starting to happen. By the same token, after the economy has absorbed the impact of technological advances, the new variations should turn positive as well. If central banks are starting to tighten their policies (like the Fed) or at least starting to reason about it (like the ECB), this means that they think the current monetary policies are really accommodating, i.e. inflation is kept low by temporary phenomena (breaking down the short term Phillips curve, as the theory concedes) and not by almost neutral monetary policies. As a matter of fact, so far history has shown that the impact of real factors on inflation is not permanent (at most longer than expected).
Moreover, regarding the structural changes lowering interest rates, there are signs that they are losing momentum. China’s surplus has already started to contract, and recent studies argue that global workforce is going to decrease – translating in more retired people with less propensity to save. In any case, when dealing with the natural interest rate, it is worth remembering that it is supposed to be a real rate, not a nominal one. This implies that even if it remained around zero for a long time, it would mean nominal rates would roughly follow the inflation. In fact, a world with a zero natural interest rate could be compatible with any level of inflation. Thus, as inflation is going to perk up, nominal rates should follow to keep real rates around zero.
These arguments let the main central banks assume that their policies are still accommodating, that inflation will take off, and that so it is correct to start tightening – very cautiously – their policies (the Fed has already started, the ECB might follow soon next year). Moreover, a strong incentive to act is that this long period of ultra-low rates is excessively inflating the stockmarket and is pushing investors in ever riskier assets. The last thing central banks want is to be remembered as the main cause of the next financial crises.
2017.10.14