Comment on Inflation

April 9, 2019

The current U.S. economic upswing is just three months short of setting a new record for longevity, and yet inflation remains stubbornly below the Federal Reserve’s target. Just as it proved frustratingly hard to lower inflation sustainably during the last third of the twentieth century, policymakers in the United States, Japan, and Europe have grappled lately with inflation that is lower than desired.

The two-way inertia of inflation over a lifetime of economy watching suggests to me a fresh way of conceptualizing price equilibrium. Regarding the determination of a price for a given good or service, equilibrium occurs at a specific level that equates the quantity demanded with the quantity supplied. So long as underlying conditions that affect either the upwardly sloping supply or downwardly sloping demand functions do not change, market forces will hold the price stable close to a single point.

But when considering inflation, the average behavior of prices for all goods and services, equilibrium appears to manifest itself as a directional trend instead of a fixed point. Officials at the Bank of Japan think this may be so because of the influence of expected inflation on actual inflation and because inflation expectations are dominated by actual inflation. The more that inflation runs above or below target, the more convinced people become that it will continue to do so. An enduring change in inflation psychology requires an enormous shock. The U.S. recessions of 1970, 1973-75, and 1980 weren’t powerful enough. CPI inflation fell from 6.2% in January 1970 to 2.7% in mid-1972, only to rebound to 12.3% at end-1974. A drop to 4.9% at end-1976 was likewise followed by a climb to 14.8% in March 1980, and three months after the next trough of 9.6% in mid-1981, CPI inflation was back up to 11.0%. Only after former Fed Chairman Volcker tied monetary policy on a weekly basis to money growth, allowing a severe recession to persist for 1.5 years and the federal funds target to reach 20%, did long-term inflation expectations begin to move lower.

The process of rising inflation and subsequent disinflation were each prolonged. In five-year increments, U.S. CPI inflation had averaged 1.9% per year from March 1955 to March 1960, then 1.3% in the five years to March 1965, 4.1% through March 1970, 5.8% through March 1975 and 8.7% through March 1980, when a high-water on-year pace of 14.8% was touched. Subsequent 5-year inflation rates of 5.8% through March 1985, 3.9% through March 1990 and even 3.3% through March 1995 were still lofty by current standards. The pace steadied at 2.5% in the five years to March 2000 and 2.4% in the five following years to March 2010, but then decelerated anew to 1.6% in the five years through March 2015. CPI inflation has averaged 1.5% over the past five reported years.

Quantitative monetary stimulus hasn’t influenced inflation expectations as much as quantitative tightening did nearly 40 years ago. When one looks at the Japanese experience too, it appears that additional developments beyond the scope of monetary policy will be necessary to turn the tide. Japan’s overnight money rate target was last above 0.50% in September 1995, and CPI inflation in that economy is currently just 0.2%.

The world economy is much more interconnected now through trade and financial transactions than it was when the Fed fought double-digit inflation many decades ago, and that has seemingly made it even harder to shift price expectations. It doesn’t help either that governments no longer coordinate macroeconomic policies as closely they once did.

Other economies are also experiencing very low and, in several cases, falling inflation. The 1.5% rise in U.S. consumer prices in the twelve months through February 2019 followed on-year advances of 2.2% in February 2018 and 2.7% in February 2017. In the euro area, headline CPI inflation of 1.4% is the same as in the previous twelve-month period. Japan’s 0.2% inflation is down from 1.5% a year ago. British CPI inflation slowed from 3.2% two years ago to 2.7% last year and 1.9% at latest report. Swiss inflation remains below 1% at 0.7% and is not expected to move above 1.0% before 2021. Chinese inflation since a year ago has halved from 2.9% to 1.5%, and Indian consumer price inflation dropped from 4.4% to 2.6%. When the global economy looks more inflation-prone, this factor will shift from an inflationary headwind to a tailwind, and central banks will have a better chance of manipulating sluggish inflation expectations upward and closer to target.

Copyright 2019, Larry Greenberg. All rights reserved. No secondary distribution without express permission.



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