Why it’s time to rethink our assumptions about inflation


Masaaki Shirakawa is a former Governor of the Bank of Japan.

Inflation risk assessments now take center stage in global financial markets after last week’s surprise jump in the annual US consumer price inflation rate for April to 4.2%. The question is whether the rise in inflation is transitory.

As long as we take a traditional approach to examining the output gap, which is supposed to affect inflation, the official view of the US Federal Reserve is understandable, because the two big events that narrow the output gap to my opinions are both essentially one. in nature.

First, the successful rollout of vaccination in the United States simply means that the economy will return to the pre-COVID era, characterized by low inflation. Second, it is unrealistic to expect continued fiscal stimulus on the current scale. Ultimately, a fiscal cliff, or a decline in fiscal stimulus, is inevitable.

But that sort of reasoning doesn’t resonate with nervous investors who are understandably concerned about a possible shift in recent trends – from a period of disinflation to inflation.

Looking at the global trend since World War II, inflation started to rise from the mid-1960s and peaked around 1980. Then the inflation rate gradually began to decline and the economies advanced. have experienced a long period of price stability. A period of low inflation – or rather fear of deflation – came after the global financial crisis of 2008, although Japan experienced this entire cycle 15 years ahead of other advanced economies.

What caused this change? Some emphasize the role played by central banks. Of course, central banks are important, but to point out is naive or superficial: central banks do not exist in a vacuum. We need to examine the factors influencing the monetary policy decisions of central banks – the political, societal and intellectual environment. I feel uncomfortable when I hear central bankers say “we know how to deal with inflation, even if the risk of inflation were to materialize.” The problem is not a technical one.

Traders watch the screen that shows Federal Reserve Chairman Jerome Powell’s press conference: The reasoning doesn’t resonate with nervous investors. © Reuters

What determines the trend inflation rate? In fact, inflation rates have remained well below the 2% target since the global financial crisis, despite the touted framework of inflation targeting and extremely aggressive monetary easing. This clearly shows how limited our knowledge of the dynamics of inflation is.

Let us start with the famous proposition often quoted by economists according to which “inflation is always and everywhere a monetary phenomenon”. What exactly do we mean by that? If this means that inflation is generated by an increase in the central bank’s balance sheet, or central bank money, this is clearly refuted by the recent experiences of many advanced economies.

I am not implying that central banks cannot be an anchor for price stability. Central banks can avoid deflation by acting as a lender of last resort to prevent the financial system from collapsing.

Almost all historical examples of modern day deflation are confined to the 1930s and relate to the collapse of the financial system. Central banks can also stamp out runaway inflation through aggressive monetary tightening, as Paul Volcker, then chairman of the US Fed, did from 1979. But all this does not mean that central banks can fix the rate. inflation at the target level.

The intellectual framework most often used by economists is the Phillips curve showing the relationship between the output gap and the rate of inflation. Over the past few decades, however, the link between inflation and the output gap has been very moderate, possibly because companies are losing their pricing power due to globalization and technological change. I do not yet see convincing evidence that this situation is changing.

In view of the current massive fiscal expansion, the theory that price levels are a “fiscal phenomenon” is particularly interesting. If people see a balanced budget as unsustainable, the only way to get the budget balanced is either through debt default or inflation.

Some argue that when it comes to advanced economies, outright default is unthinkable because central banks can always buy government bonds when needed. In such cases, high inflation will certainly result. Or, to be more precise, a rise in prices triggered by the flight to a safe haven currency and the resulting depreciation of the currency. This theory captures some important aspects of the dynamics of inflation, but it is silent about the short-term movement of the inflation rate.

Finally, there is a theory that emphasizes the role of demography in explaining the dynamics of inflation. As Charles Goodhart and Manoj Pradhan argue in their recent thought-provoking book The great demographic shift, the favorable demographic trends, responsible for the disinflation trend since the 1990s, are now reversed: the decline in working-age populations will push up wages and therefore inflation.

I totally agree with the importance of demographic changes, but I am not entirely convinced by their argument. The working-age population is not only workers as a definition, but also constitutes the base age cohort of expenditure. Thus, the decrease in the working-age population also means a decrease in the demand for goods and services.

On top of that, we need to think about the impact of a declining population, which is disinflationary, as opposed to rapidly aging. It started in Japan in 2009 and will debut in China in a few years.

The current concerns about the risk of inflation are quite legitimate. If the question is about an inflation risk assessment, say, over the next three years, the reflections on the above arguments cause me to distance myself from the fear-mongers. But, given our limited knowledge of the dynamics of inflation, I am not attached to this position. What I mean is just that focusing on inflation risk is dangerous when it comes to assessing the appropriateness of current monetary policy parameters.

As I have said many times here, it is not inflation but financial imbalances that have caused huge economic swings in recent times. Prolonged monetary easing creates a strange balance between low growth, low inflation and low interest rates. I feel that we need to reconsider the dominant intellectual framework of monetary policy.


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