Why Is Inflation So Low?

Op-ed in El Pais

June 28, 2015

Since central banks began their quantitative easing (QE) programs to counter the effects of the global financial crisis, seven long years ago, the alarm announcing the imminent arrival of inflation has been pervasive. Monetarists screamed, terrified that the rapid increase in central banks' balance sheets would generate high and accelerating inflation that would require rapid rises in interest rates, with the consequence that the remedy (the QE programs) would end up being worse than the disease (the crisis). Fans of Taylor rules—the rules developed by Stanford University professor John Taylor in the 1990s to describe interest rates as a function of the equilibrium interest rate, the output gap, and the differential of actual inflation with respect to the inflation target—have regretted that those rules have consistently indicated that interest rates were too low. In both cases the alerts have had a marked Republican (in the United States) or German (in Europe) accent.

The collapse of commodity prices has undoubtedly helped to contain inflation and bring it into temporary negative territory. But the reality is that inflation has been very low everywhere for years. In the United States the core consumption deflator stands at 1.3 percent year-on-year; in the United Kingdom and Europe core inflation is at barely 1 percent or below, and in Japan at just 0.1 percent. This phenomenon is not unique to the countries that were at the epicenter of the crisis. All central banks in the developed world that hiked rates after 2010 have had to ease policy again, some of them quite aggressively. Forecasts of rising inflation have seriously erred so far.

The causes of contained inflation are varied and will almost certainly generate years of research. On the one hand lays the fragility of inflation expectations and the weak confidence that central banks will be able to restore price stability. In the unfortunately politicized debate over quantitative easing, characterizing the use of bond purchases as an "unconventional policy" is misleading, because interest rate cuts—"conventional policy"—and bond purchases are equivalent and complementary ways of achieving the same objective, a structure of interest rates and asset prices that generates balanced growth and stable inflation. But the label has led central banks to use excessive caution in applying quantitative easing and the public and investors to distrust its effectiveness.

This distrust has blunted QE's effect on real investment (which has horizons of several years) much more than on financial investment (which has shorter horizons), thus contributing to increasing inequality. This in turn has stabilized medium-term inflation expectations below the target, creating downward pressure on actual inflation. The fear that bond purchases would generate moral hazard among governments and thus uncontrolled fiscal deficits has also proved unfounded. If anything, the desire to avoid accusations of moral hazard has generated excessive zeal in deficit reduction in the United States, the United Kingdom, or Europe, preventing a more buoyant recovery.

On the other hand, changes in global labor markets induced by the combination of a deep crisis that has facilitated the incorporation of rapid technological progress and structural reforms (in health care in the US, in labor markets in Europe) seem to have increased the capacity of the economy to create jobs without generating wage inflation. New technologies allow more active management of hours worked; in the United States and the United Kingdom many service sector employees are given very short notice of how many hours they will work (and therefore how much money they will earn) that day or week. Such technology has thus shifted the impact of short-term fluctuations in demand from employers to workers, increasing their uncertainty about future income and weakening their ability to demand higher wages.

The increase in part-time jobs generates a composition effect that limits wage increases for a given level of unemployment. Japanese workers have experienced this wage stagnation in recent decades, as US workers are now, and probably Europeans will as well. In Spain, José Ignacio Conde Ruiz and his coauthors in the blog "Nada es Gratis" show that approximately 30 percent of workers who had a permanent contract in 2007 now have a temporary contract, are self-employed, or unemployed. The nominal median income for those who have remained in the same company with the same permanent contract has increased 14 percent since 2007. However, for those still with a permanent contract but who have changed companies, the nominal median income has fallen 17 percent, and over 40 percent for those who have shifted from a permanent to a temporary contract.

In addition, we may be too pessimistic about the growth potential of the economy. The technological progress that is permeating all economic sectors is not translating into improvements in measured productivity. But it is quite possible we don't know how to properly measure technology's impact on productivity and thus underestimate the decline in the GDP deflator and the associated increase in real GDP growth. What is the value of a service that suddenly becomes free in exchange for user information that can be monetized in the future in a monopolistic setting? What is the value of the improved services of free applications offered with each new smartphone upgrade, which may increasingly reduce demand for other market services and replace them with unmeasured home production or leisure? If a software package offers more and better services at the same price, has the price dropped?

The drama of the financial crisis and the tightening of financial regulation have increased the risk aversion of consumers, entrepreneurs, and financiers. The combination of insufficiently stimulative economic policy, more flexible labor markets, and potentially mismeasured technological progress implies a greater output gap than what conventional measures suggest, providing a plausible explanation for the absence of inflation. It is possible that the United States will soon reach the point where inflation could begin to normalize, but Europe is still many years away from that point. The key message is that interest rates are low, but not too low. After more than five years with inflation below the target, the prudent course of action will be to give growth a chance to accelerate.