Inflation: Dodo or Phoenix?

In the late 1970’s and early 80’s annual consumer price inflation in Ireland hovered around 20% and it would have seemed fanciful to anyone living through that period there would come a time when prices would hardly change from one year to the next. Yet, annual Irish inflation since euro membership in 1999 has averaged 1.8% and has been lower still in the last decade , at just 0.5%. Of course Ireland has not been unique in this regard, with inflation in the euro area averaging 1.4% over the past decade or 1.2% excluding food and energy.

The Covid pandemic has added additional disinflationary forces, with the demand shock trumping that on supply, at least to date, and annual inflation is currently negative across the euro area, including Ireland. Some argue , though,that this long period of largely stable prices may be coming to an end, in large part as a consequence of the policy measures taken to combat the economic dislocation caused by the pandemic.

Inflation, as Friedman noted, is everywhere a monetary phenomenon and the money supply is certainly expanding at a rapid clip in developed economies; in the US broad money supply growth was an annual 23% in August, while the July figure in the euro area was over 10%, including 13.2% in Ireland. In fact most of this is driven by overnight deposits, as households, in particular , are effectively forced savers as a result of economc restrictions, leading to a rapid build up of monies in current accounts that would normally be spent.

How quickly these deposits will be spent on a return to more normal conditions is one question but the broader monetary argument is that banks in Europe and the US now have an unprecedented amount of excess reserves, which can be used to create loans and hence money, so the potential is there for a longer period of excess monetary growth and inevitable inflation.

The Monetarist case is based on the Quantity Theory, which has an identity at its core- the value of national income (PY) equals the money supply (M) times the average number of times that money circulates ( V, the velocity of circulation). The theory assumes that V is pretty stable which if true means that monetary growth above the potential growth of the real economy will push up prices. V can and does fall, however, so ‘excessive’ monetary growth may simply be offset by a fall in Velocity, leaving national income little changed.

It is also the case that bank reserves are a necessary condition for loan growth but not a sufficient one , as the ECB has found in recent years. Firms and households may not be wiling or able to take on fresh debt and banks may also be constrained by low profitability and capital issues, leaving monetary policy essentially pushing on a string..We have also pointed out in previous blogs that the huge fiscal stimulus seen in response to the pandemic is not funded by monetary creation, at least to date, and will ultimately be paid for by taxapayers, albeit at a borrowing cost kept low by central bank purchases of government debt.

In a world of globalisation and largely free trade any excess demand for goods in a given country can anyway be met by higher imports, with little or no impact on the price level. On that view a generalised rise in inflation across the globe requires the elimination of excess supply at a global level and as central banks have discovered this makes it extremely difficult to achieve a desired level of inflation with monetary measures alone. The pandemic has ceratinly impacted supply but it is not clear there will be a significant long term impact on global capacity. Absent that, the structural factors that have kept consumer inflation low may well continue to work. Asset prices are different, though, in that excess demand there can and does lead to inflation, because supply is constrained, such as land and housing in a given country or equities via buybacks. So liquidity can certainly drive asset price inflation , if not consumer prices.

Are Inflation targets too high?

Inflation targeting by policy makers emerged in the early 1990’s and is now part of the standard toolkit for most central banks, with operational independence from government also the norm. The idea is straightforward; if the central bank commits to hitting a specific inflation rate, that rate will impact expectations and eventually will help to anchor price changes. Too high a figure means that purchasing power is eroded at an unacceptably fast pace, while too low risks periods of deflation.

The latter view persuaded central banks to eschew a zero inflation target, and the figure of 2% is very common, although of course it means that prices rise by 22% over a decade and by 50% in a generation.  Hardly stable prices then, although one should remember that such targets  were often set some time ago and at a period when inflation was generally above that figure.In contrast, many central banks have been wrestling with the opposite problem for some time i.e. inflation is persistently below target.

In the US, for example, core inflation ( the CPI excluding food and energy) has been below 2% for almost a decade, while in the euro area the last time core inflation exceeded 2% was back in 2003. This points to structural factors at play, rather than purely cyclical drivers.

Standard inflation models , however, generally posit a cyclical  link between economic activity and inflation, with periods of stronger growth resulting in an acceleration in inflation. The link is often based on the Phillips curve, the idea that falling unemployment will boost wage growth and hence lead to price rises. Consequently, most central banks expected inflation to pick up given falling unemployment, particularly as rates for the latter are now very low by historical standards in some countries, including the US and the UK. Yet wages have not picked up as expected ( the Phillips curve has flattened), reflected a range of factors, many of them structural, including globalisation and free trade, a shift in employment composition to lower productivity jobs, the rise in self employment,  fear of job losses and the decline in trade unions .

There may be other factors directly impacting inflation, such as the greater ease of price discovery in a digital age and the growth of disruptive technology, ( examples might be Amazon and Uber) which are replacing traditional models of distribution. Technology change is general is also shifting the aggregate supply curve rightward, so putting downward pressure on prices.

Yet the Fed and the ECB are still wedded to a 2% inflation target, despite missing it to the downside for a long period. Fed chair Yellen did acknowledge recently  that inflation was not behaving as expected ( calling the recent inflation performance ‘a mystery’) but the FOMC and the ECB are both of the view that cyclical factors will eventually win out, pulling inflation up to target.They may be ultimately proven right, although the recovery is now pretty long in the tooth, particularly in the US, and the Fed has revised down its view of long run potential growth ( now sub 2%) although not of long run inflation, still at 2%.

Does it matter if inflation was to stay in a 1%-1.5% range. It’s obviously better than 2%  for many people in an era of weak wage growth but it does raise a policy issue- if ‘equilibrium inflation’ is now below 2% due to structural changes, then policy will be too loose if it is set to hit 2%. The liquidity currently flooding the world has indeed driven up prices, but equities and property rather than the price of goods and services.

 

The Return of Inflation?

Inflation in the Euro Area has risen sharply of late, with the flash estimate for February at 2%, from 0.6% in November, and is now  at the highest rate in four years. Consumer prices have also picked up momemtum in the other major economies: In the UK the inflation rate has accelerated from 0.9% to 1.8% in four months while in the US the increase is from 1.6% to 2.5% over the same period. As a consequence markets have shifted away from the fear of deflation and now the issue is whether this upturn in prices will prove short-lived or is it the beginning of a more sustained period of inflation, ultimately requiring  a faster policy response than currently priced in to markets. That change is clearest in the US, with the Fed now expected to raise rates again this month.

The more benign interpretation of the inflation trend  is supported by measures of core inflation, which exclude volatile components like Food and Energy. On that definition, the euro inflation rate is at 0.9%, unchanged over the last three months, and so the rise in inflation is due to a rebound in energy prices ( up an annual 9.2% in February) and unprocessed food ( plus 5.2%). These changes partly reflect base effects ( large monthly falls a year ago now dropping out of the annual figure) and the recent increase in global commodity prices, notably crude oil. In the US the Fed’s preferred measure of inflation is the core consumption price deflator, and that is rising at an annual rate of 1.7%, or at an annualised  rate of 1.6% over the past three months, again not flashing red.

What determines core inflation? Profit margins have an impact ( can firms pass on higher import prices in the UK for example) but the main factor is labour costs, and in most countries wage growth remains subdued and is much lower relative to unemployment than in the past. Why this is the case is the subject of much debate but in the absence of a pronounced pick up in wage inflation it is difficult to see price inflation accelerating for a prolonged period.

Headline inflation is what matters to consumers, of course, and the recent rise will dampen real incomes and  probably reduce real consumption and hence GDP growth. A 2% inflation rate is therefore  worse for the economy  than a 1% rate, yet Central Bankers have argued the opposite, as most use a 2% inflation figure as their definition of stable prices. How this became conventional wisdom is hard to fathom ( prices rise by 22% in a decade and just shy of 50% in 20 years, hardly a good measure of stability) while the fear of deflation is strong, even though Japan, the land of falling prices, has not really suffered in terms of its real GDP growth per head. Inflation at 2% may be fine with wage growth of 4%, as was the case , but not if wage growth is 2% or below, as appears to be the ‘new normal’. There is not much central bankers can do in the short term to influence energy or food prices, of course, but higher headline inflation will dampen real spending in the absence of an acceleration in nominal wage growth.