The changing nature of inflation

The IMF’s latest World Economic Outlook has made some very interesting observations about the changing nature and growing stability of inflation.

Most notable is the following chart:

And also this one:

As the IMF notes:

Despite large rises in unemployment during the Great Recession, inflation has been remarkably stable in almost all advanced economies. This is different from the recessions in the 1970s and 1980s, when inflation fell much more when unemployment rose.

In short, the quandary isn’t “where is the inflation?”, but quite the opposite: “why didn’t inflation fall more, given the slack in the global economy and the increase in jobless rates?”.

One explanation, of course, is the success of inflation targeting policy, and unconventional central bank actions deployed precisely so that targets could be continuously met throughout the crisis. In short, from a deflation-avoidance point of view, there’s much to be happy about.

Indeed, as Martin Wolf observes in the FT on Wednesday:

Why are the high-income countries not mired in deflation? This is the puzzle today, not the absence of the hyperinflation that hysterics have wrongly expected. It is weird that inflation has remained so stable, despite huge shortfalls in output, relative to pre-crisis trends, and prolonged high unemployment. Understanding why this is the case is important because the answer determines the correct policy action. Fortunately, the news is good. The stability of inflation seems to be a reward for the credibility of inflation targeting. That gives policy makers room to risk expansionary policies. Ironically, the success of inflation targeting has revitalised Keynesian macroeconomic stabilisation.

Which does give rise to the question of whether inflation targeting will be as successful on the exit side.

According to the IMF, there’s every reason to suspect it will be:

If the inflation stability during the Great Recession reflects a flat Phillips curve and the anchoring of inflation expectations, there seems little risk of strong inflation pressure during the ongoing recovery.

The only exception, however, is if the natural rate of unemployment — NAIRU — is higher than we expect it to be, perhaps because what was deemed to be spare capacity, or slack, was eliminated permanently from the system:

However, there is a risk that inflation could become much more sensitive to output gaps during future periods of expansion. For example, there could be nonlinearities in the Phillips curve: the slope of the curve could be flat when the economy faces cyclical unemployment but steep if unemployment falls below the NAIRU. This concern becomes particularly salient if estimates that suggest there are now large output gaps and high cyclical unemployment (see Figure 3.2) turn out to be wrong. For example, it may be that slower productivity growth and yet-unrecognized structural changes have lowered potential output and raised the NAIRU—just as during the 1970s.

To translate that a little bit, this is the idea that a given amount of unemployment is always “natural” in the economy — which reflects job churn, capacity, salary competition and the general point at which employment is neither inflationary nor deflationary.

It is, effectively, the employment level the economy needs to balanced supply with demand.

Wherever that equilibrium lies determines whether the unemployment level is inflationary or deflationary for the economy. So if NAIRU lies at 4 per cent, but unemployment is only 3 per cent this is generally considered inflationary. If NAIRU is 4 per cent, but unemployment is 5 per cent, then the opposite is true — because there are more workers competing for jobs, who are prepared to drop wages for a source of employment.

Currently there is a presumption that NAIRU is actually quite low in historical terms. That is, the economy can afford to have many more people employed than it could do in the 1970s.

However, the rate is still much higher than it was in the boom years of the Nineties and Naughties, when many more people could be employed without inflationary or deflationary consequences. In short, that means fewer people can now be employed without overburdening the economy with the sort of output levels that would inevitably lead to a deflationary price correction.

What the IMF is worried about, however, is what if on the exit, capacity which was thought to be available transpires not to be because it was shuttered, disabled or permanently taken out of service. Or, for that matter, because some element of workforce has permanently taken itself out of the work pool because it can survive quite happily without work.

In that event NAIRU would be higher than what we thought it was due to less need for employees in the general economy, meaning any fall in unemployment could take the unemployment level dangerously below the natural rate — bringing with it the inflationary consequences associated with having too many people employed relative to the capacity of the economy.

The 1970s offer an interesting example, in that sense. This is because the era featured high unemployment, but was also mostly associated with rising inflation. One reason for that was because unemployment was still lower than NAIRU, which was increasing rapidly due to the oil shock and the busting of the unions. (On the oil side, the economy could only afford to employ so many people before coming against the inflationary choke point which was the oil input. On the wage front, the employees it was previously forced to employ on high wages it was no longer being forced to.)

This eventually had the effect of raising NAIRU ever further beyond the unemployment rate, which had the unfortunate consequence of stimulating inflation.

So in some sense the unemployment rate was chasing the rising NAIRU.

It was only when it caught up with NAIRU that inflation ceased to be a problem.

Drawing on the lessons of the 1970s, the IMF thus concludes:

In the wake of the Great Recession, there is political urgency to reduce unemployment, as during the 1970s. In addition, the unprecedented growth in central bank balance sheets has been suggested as a possible vector through which central bank independence could be undermined during the recovery.16 For example, capital losses on large bond holdings could expose central banks to political pressure. Similarly, there are concerns that the stimulative effects of unconventional monetary policies may gather momentum as the recovery strengthens, and these policies may be hard to reverse. We do not analyze these issues here (see Chapter 1). Instead, what our analysis underscores is that, whatever the source, limits on central banks’ independence and operational restrictions that limit their flexibility in responding to evolving challenges can cause problems and must be avoided. In short, the dog did not bark because the combination of anchored expectations and credible central banks has made inflation move much more slowly than caricatures from the 1970s might suggest—inflation has been muzzled. And, provided central banks remain free to respond appropriately, the dog is likely to remain so.

Though the other important lesson relates to productivity, since any fall in productivity has the potential decrease NAIRU as well.

Given that, it’s worth bearing in mind the eventuality that the reason deflation was avoided — despite excess capacity and high unemployment — was because unemployment never surpassed NAIRU, which itself was rising all the time much like in the 1970s.

Of course, there is also the chance that at the zero-lower bound everything simply behaves a little bit unexpectedly. As Paul Krugman for example has noted regarding the “is NAIRU actually much larger than we think” meme:

…I’m in the camp that says that the expectations-augmented Phillips curve breaks down at low inflation rates, thanks to nominal wage rigidity. It’s one thing to squeeze inflation down from 10 percent to 4 percent; squeezing it down from 2 percent to 0, or even deflation, would require that lots of workers take actual wage cuts — and that’s something that tends not to happen. Instead, we find ourselves with many workers having zero wage change, while some have gains, so that wages overall continue to rise, and so does the overall price level.

Which ultimately means stable prices don’t necessarily imply a healthy economy at all. Rather, that the factors that would usually be deflationary have been concentrated and compartmentalised in such a way that they don’t impact the overall price level.

Related link:
How central banks beat deflation – FT