Low Inflation and Slow Growth Are the New Normal

December 13, 2019

In the United States, there has been a great amount of concern about what has been the longest economic expansion in decades—one which has allowed historically low unemployment with an absence of inflation. This would seem to be something people should welcome, even praise as the rarely attained soft landing for an advanced economy.

The fact that this inflation-free slow and steady expansion has been coincident with low nominal interest rates, a large Federal Reserve balance sheet, and generally loose fiscal policy, however, is troubling to many economists.

Upon reflection, those worriers should probably calm down. The situation is less unusual and certainly less troubling than it appears. First, it should be recognized that this seems to be the common pattern following a banking crisis. Second, the relative absence of inflation, and the high degree of labor supply elasticity, is also more common than thought. Third, as a result, the risks of ongoing macroeconomic policy support for expansion therefore in reality are far lower than some foresee.

Looking back, all the advanced economies which experienced financial crises in the early 1990s—Canada, Finland, Japan and Sweden—had long steady economic expansions once their recoveries started. In fact, these expansions went on far longer than were projected from simply reemploying the idled labor and capacity from the crisis, even allowing for some catch up in investment.

In Japan's case, the recovery would have probably been unbroken to date, had it not been for the North Atlantic financial crisis of 2008–09. And these were all expansions where GDP fluctuated less than in previous expansions on average.

I identified this pattern in the early 2000s, before the American and European crises. But given the limited number of cases, it was and remains difficult to argue that there is statistical evidence for such a common path. There are some good intuitive reasons though why such a pattern makes sense.

After a severe financial crisis, generally households and businesses rebuild their balance sheets. Risk aversion goes up, both in the genuine sense of how most individuals feel, and in the functional sense that bank supervisors and managers exert far more care than they did precrisis. Workers are more willing to sacrifice wage demands for hopes of stable employment. As a result, there tends to be lower leverage and fewer financial imbalances in the economy.

Those factors also feed into the lower rate of inflation persisting even as unemployment falls to new lows, though that is not all that contributes to that outcome. Periods of high inflation actually are much rarer in the advanced economies than people assume despite the obvious evidence.

The United States suffered essentially around 10 years of sustained high inflation over the last century plus; Japan suffered two periods in a century, one of which was due to war finance taking over monetary policy. It looks more and more like the 1970s were an aberration rather than an example of a recurrent threat. As a result, the ability of the economy to bring the underemployed or the supposedly out of the workforce into paid jobs is higher than most forecasters have built into their models.

Crucially, this combination means that relatively loose monetary policy with large central bank balance sheets is not dangerous—as Japan has demonstrated since 2003. Various financial scolds talk about the re-emergence of bubbles in the United States or eurozone as just around the corner.

Yet neither Canada, Finland, Japan nor Sweden have seen financial instability arise as a result of their long post-crisis expansions. It is doubtful that the preceding recessions usefully purged the economies of excess—the human and political costs of crisis are too high to justify that, and the mechanisms I posit for stability should in part be achievable through regulatory means without a crisis. The fact remains, though, that financial crises do seem to be regularly followed by dampened financial excess in terms of leverage.

The sharp simultaneous slowdown in productivity growth in the West starting around 2004, notably precrisis, should remain a source of deep concern for all economists as well as policymakers.

Clearly, something is wrong, as shown in the lack of corporate investment response even to growth and tax cuts. Since the productivity decline predated the financial boom and bust, though, it is a separate issue from the slow steady expansion we are experiencing. It appears to be normal, and therefore should be enjoyed.

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Adam S. Posen Senior Research Staff