Friday, September 30, 2016

The Loflation Pandemic

The IMF reports in the latest WEO that the world has a low inflation problem:
By 2015, inflation rates in more than 85 percent of a broad sample of more than 120 economies were below long-term expectations, and about 20 percent were in deflation—that is, facing a fall in the aggregate price level for goods and services (Figure 3.2). While the recent decline in inflation coincided with a sharp drop in oil and other commodity prices, core inflation—which excludes the more volatile categories of food and energy prices—has remained below central bank targets for several consecutive years in most of the major advanced economies.
Here is the IMF's figure that nicely summarizes this development:

This figure shows this trend toward low inflation started around the time of the Great Recession and has only grown. Given its global nature, I am going to call this development the loflation pandemic. So what is behind it? Here is the IMF's explanation:
Economic slack and changes in commodity prices are the main drivers of lower inflation since the Great Recession.
The commodity story, in my view, is limited in how much it can explain since commodity prices have gone up and down since 2008. Moreover, as Jim Hamilton and Ben Bernanke argue, just under half of the commodity price decline since mid-2014 can be attributed to weak global demand. Weak commodity prices, in other words, are themselves partly the result of anemic demand.

That leaves economic slack, or insufficient nominal demand growth, as the main reason for the decline in global inflation. As I said before, nominal demand ain't what it used to be. This, though, begs the question as to why nominal demand growth been so weak? And why have advanced economies been so willing to tolerate it? 

The IMF does not answer these questions. All it recommends is that governments do more with fiscal and monetary policy, complemented with structural policy. This is futile. One cannot expect to change government's behavior without first knowing why they are acting as they do. 

Since the IMF seems unwilling to go there, I will. Governments in advanced economies have avoided robust aggregate demand growth--and therefore have created the loflation pandemic--because of the constraints created by their past successes with inflation targeting. Inflation targeting has become the poisoned chalice of macroeconomic policy:
Central banks have been so good at creating low inflation since the early 1990s that it is now the expected norm by the body politic. Any deviation from low inflation is simply intolerable. In the US, everyone from the media to politicians to the average person start to freak out if inflation heads north of 2%. This mentality seems even worse in Europe. Inflation-targeting central banks, in other words, have worked themselves into an inflation-targeting straitjacket that has removed the few degrees of freedom they had. It is hard to imagine Yellen and Draghi being able to raise inflation temporarily above 2% in this environment. All they can do is operate in the 1-2% inflation window. Inflation targeting's success has become it own worst enemy.  
Another way of saying this is that the space for doing macro policy has shrunk to the small window of 1-2% inflation. Not only is monetary policy constrained by this, but so is fiscal policy...  
For these reasons inflation targeting has become the poisoned chalice of macroeconomic policy. It was a much needed nominal anchor in the 1990s that helped restore monetary stability. Its limitations, however, have become very clear over the past decade and now is preventing the world from having the recovery it needs...
Put differently, no matter what the central banks try--QE, forward guidance, negative rates--they will never push beyond the public's expectation of low inflation. Fiscal policy, including helicopter drops, will also run up against this constraint. 

This constraint also means that policymakers may not have the flexibility they need to stave off recessions:
If a trucker gets stuck in traffic jam, he will have to temporarily speed up afterwards to make up for lost time. On average, his speed for the trip will be the legal speed limit but only if he temporarily speeds up after the traffic jam. Likewise, an economy may need temporarily higher-than-normal inflation after a sharp recession to return to full employment. This also implies temporarily higher-than-normal nominal demand growth. On average, this temporary pickup will keep inflation and nominal demand growth on target. Running a little hot, therefore, is necessary sometimes. Currently, however, this policy flexibility is not possible.
This, in my view, is a key reason why the recovery from 2008-2009 was so weak. It is also why QE was set up to disappoint.

Inflation targeting was a much needed nominal anchor across the globe when it was first introduced in the early 1990s. But now it has put advanced economies into a low inflation straitjacket that is becoming a drag on economic growth. Until we recognize and act upon this observation, we can expect the loflation pandemic to spread.  


  1. Excellent blogging.

    "Send in the Choppers!"

    It would break the psychological straight jacket on markets today. Plus the chopper drops would work.

  2. Professor Farmer has a novel idea: raise interest rates (to appease the lowflationistas) while intervening in the equity markets (to offset the contractionary effect of higher interest rates); intervening (QE) in the government bond market (i.e., safe assets) keeps interest rates low because it reduces the supply of safe assets (i.e., we need more not less government debt in order to satisfy the demand for safe assets).

  3. Beckworth can't possibly be serious that low inflation targeting by central banks ` is a key reason why the recovery from 2008-2009 was so weak.'

    Let's take a look at Japan, which has strenuously tried to use high inflation targeting. Result? Aggregate demand far below targets, GDP growth nonexistent.

    A much more reasonable expectation would be that between 1989 and 1991, Soviet communism collapsed and disappeared and the Chinese economy converted to capitalism. More than 2 billion workers formerly locked out of the global capitalist economy came online, raising the supply of available workers by 60% over what it had been just 5 years earlier. At the same time, the internet made it possible for companies to hire workers on the other side of the world without the expense of opening a branch office there.

    When the supply of available workers permanently increases by more than 60%, wages drop. And they drop permanently. Without a living wage, workers cannot buy goods and services and so aggregate demand plummets into the basement.

    There's no mystery here.

  4. Sadly, lurking in the shadows of your approach is a distrust of the economy's ability to clear without help, the belief in the inherent instability of the private sector, and a reliance on the Phillips relation. Very Keynesian, but is it correct?

    Instead I'd look at interest paid on reserves and the resulting enormous increase in excess reserves as a significant player in what has happened to prices. The opportunity cost of lending is higher and banks don't need to pay much for deposits - they already have plenty of funds to lend if lending is worthwhile.

    I still don't like the use of any inflation as a means to stimulate aggregate spending. To me the misallocation costs outweigh the "benefits" that are only short-run at best.

    Pete Bias