Thursday, May 24, 2018

Why is Inflation Stuck so Low?

I suspect that I am like many economists, in that when I am asked about causes of inflation, I can almost see the words from a 1970 speech by Milton Friedman scrolling across my mind's eye:  "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." (It's from Friedman's 1970 lecture, The Counterrevolution in Monetary Theory.")

But this seemingly crystal-clear linkage from is gets cloudier when you recognize that the current problem is not to explain a surge of inflation, but rather the relative immobility of inflation. Friedman did not say: "The lack of inflation is always and everywhere a monetary phenomenon ..."

I've mulled over this subject before in "Mysteries of Modern Inflation" (October 26, 2017) and "Janet Yellen Doesn't Know What Determines Inflation" (November 21, 2016). In the most recent issue of the Regional Economist, published by the Federal Reserve Bank of St. Louis, Juan M. S├ínchez and Hee Sung Kim run through a list of the most commonly discussed reasons for "Why is Inflation So Low?" (First Quarter 2018, pp. 4-9). Some of the reasons seem more compelling than others, but here they are:

1) Technological Progress

It's easy to think of some ways that technological progress might help to hold down price increases: cheaper electronics and internet-related products; a rise of online shopping providing a higher level of price competition (the so-called "Amazon effect"); and the rise of the "sharing economy" firms like Airbnb and Uber holding down price increases in their industries. But it's also easy to think of industries like like health care and education where prices seem to be rising, rather than plummetting. Overall, one of the main concerns of the US economy is lack of sufficient productivity growth, not an excess of it. As the authors write about this explanation: "But why would inflation be low now if productivity has not grown faster than before?"

2) Demographic transitions

If you plot the countries of the world according to the share of elderly people, you find that countries with more older people tend to have lower inflation. Japan is a vivid example. For example, one study in Japan suggested that older workers suffer diminished skills, and thus end up competing with inexperienced workers for low-wage jobs in a way that holds down wage increases. Another possible explanation is that the elderly are often on tighter budgets, and thus are more value-oriented as consumers in a way that limits price increases. But how the broad validity of these kinds of explanations and how they apply to the US economy is not clear.

3) Globalization

A few countries have experienced high inflation rates in recent years, like Venezuela and Zimbabwe. But in most of the world, relatively low inflation is widespread. One possible explanation is that a surge in low-cost goods in global markets, especially as China entered global markets in force in the early 2000s, has helped to hold down price increases. But the authors point out that studies which have attempted to compare how global forces might affect inflation tend to find only small-sized effects.

4) Central bank actions

Maybe inflation is low because central banks all over the world have focused on keeping it low; indeed, perhaps central banks are even trying too hard to keep inflation low. As the authors write: "[T]he fact that inflation lower than the target is often considered better than inflation higher than the target may contribute to an inflation rate that, on average, is lower than the target."

5) Neo-Fisherism

Irving Fisher was a prominent American economist in the opening decades of the 20th century who pointed out that if you take the nominal interest rate and subtract the inflation rate, you get the real (that is, inflation-adjusted) interest rate. The most common use of this equation over time has been to point out that when inflation rises, the nominal interest rate also tends to go up. But the neo-Fisherian hypothesis is that if central banks are keeping the nominal interest rate low (to stimulate the economy), then the gap between the nominal and the real interest rate--which is the rate of inflation--must also be low. The implied policy suggestion is that raising nominal interest rates could also bring a rise in inflation. This hypothesis is counterintuitive for conventional macroeconomics, in which higher nominal interest rates should tend to slow down the economy and reduce inflation.

A final theory not emphasized here, but mentioned by Olivier Blanchard in a recent article, is that when inflation has been low for sustained period of time, people and businesses stop worrying about inflation in the same way. When the reality and risk of inflation isn't salient to economic decision-making, companies don't give semi-automatic pay raises to make up for inflation. Sellers don't semi-automatically raise prices to make up for inflation.

There doesn't have to be one right answer here. It can be a "Murder on the Orient Express" plotline where everyone contributes to the outcome. My own sense over the last couple of decades is that I no longer worry as much about rising inflation, or about inflation getting out of  hand. Instead, I worry about how buying power might manifest itself in asset price boom-and-bust cycles, like the dot-com boom of the late 1990s or the housing price boom before the Great Recession. Maybe inflation is so low in part because the economy has found other ways of blowing off steam.