Going down: falling inflation complicates the task for central banks

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This post was originally written and published on the blog in October 2014. Events since have exacerbated the disinflationary forces at large in the world economy. Rather than writing a completely new post, it seems more effective to update this post. To make it clear which sections are new, I’ve put them in italics.

Inflation has fallen significantly in the eurozone this year, forcing the ECB to announce a series of measures to head off deflation. So far, though, there is little sign of an end to the disinflationary trend. Here we are, almost a year later, and the disinflationary trend is if anything, even more entrenched – the slowdown in China’s economy providing a new roudn of disinflationary pressures.

In May 2014, the eurozone headline inflation rate fell to 0.5% year-on-year (y/y) from 0.7% (y/y) in April, taking it to its lowest reading since autumn 2010 and continuing a descent that began in November 2013 since when inflation has remained stubbornly below 1%. June saw the rate of inflation drop further, to 0.4%, the lowest level in five years. Data from EuroStat (the European Commission’s statistics bureau, click here to find out more) again showed a headline rate of 0.4% in August year-on-year with the core rate (excluding the more volatile components) at 0.9%. EuroStat have since confirmed that eurozone consumer price inflation hit a new five-year low of 0.3% in September 2014. The latest data shows headline inflation edged back down to 0.3% y/y in November 2014 (having risen to 0.4% in October) with core inflation unchanged at 0.7% y/y.

So far in 2015

Disinflation leaves the eurozone vulnerable to deflation

Apart from raising doubts about the credibility of the European Central Bank (0.3% being a fraction of the ECB’s inflation target of “close to but below 2%”) such ‘lowflation’ (a term recently coined in a speech by Christine Lagarde, managing director of the International Monetary Fund, click here to find out more) leaves the eurozone looking very vulnerable as there is currently barely any inflationary cushion to shield the eurozone economy. The deflationary impact of an extraneous economic shock could conceivably tip the eurozone economy into a more severe deflationary spiral.

Figure 1: The downward trend in eurozone inflation in recent years is clearly illustrated in the drop of eurozone HICP below the 2% inflation target (as shown in blue)

The graph below is interactive – move your mouse over the timeline section below the graph to change the time period shown on the graph. Thanks to FRED (Federal Reserve of Economic Data) at Saint Louis in Missouri for this graph.

Prices are falling around the world

Disinflation is a worldwide phenomenon just now. In the UK and United States, inflation is below the 2% level targeted by the Bank of England and the US Federal Reserve. Inflation in Greece, Italy and Spain is now negative. In China, inflation is also below 2%, way under the 4% target set by the central government. In Sweden, where prices have fallen in 16 of the last 24 months, the Riksbank this week responded by cutting interest rates to zero.

Falling oil prices exacerbating disinflationary pressures

The latest blast of disinflation is a consequence of the fall in oil prices from around USD 115 in late June to below USD 80 today (click here for an interactive graph of US crude oil prices). While falling oil prices are a boon to oil importers the bad news is that they appear to be the result of a slowdown in growth around the world. So while lower energy prices should boost consumer purchasing power, they may also reinforce the notion among consumers that they can buy cheaper next month. In May, ECB president Mario Draghi, talked of “fertile ground for a pernicious negative spiral, which then also affects expectations.”

Oil prices have of course fallen further in 2015 providing a further blast of  disinflation across the global economy.

Lowflation is set to stay a while

In June, Mr Draghi announced measures aimed at countering falling inflation rates but he also markedly downgraded the central bank’s inflation forecast. The ECB’s new projections show inflation is expected to remain well below its target until the end of 2016, with a downgrade in the forecast from 1.7% to 1.5% (click here for a comprehensive overview of the ECB’s current inflation forecasts). In October 2014, Andy Haldane, Chief Economist at the Bank of England, noted that bond markets are pricing negative real interest rates for the next 40 years and the Riksbank said the absence of inflationary pressures leds it to believe rates would be at zero until mid-2016.

The absence of inflationary pressures is now such that last week the  IMF called on the leading central banks to hold off from raising interest rates. The IMF made its comments in a paper ahead of the G20 finance ministers’ meeting in Ankara on 06 – 07/09/15. The main message is that the slowdown in China is having a larger effect than expected. Emerging markets have also become more vulnerable, and there is virtually no productivity growth in the advanced economies. The IMF urged the Fed not to go for a premature rate increase for as long as there is no hard evidence of meaningful wage and price pressures. And for the ECB the message is to extend the QE programme.

Lowflation tends to boost public debt-to-GDP ratios

Such extremely low inflation rates aggravate the task of reducing debt burdens and improving competitiveness across the eurozone. IMF research has shown that in the past lowflation has tended to result in an increase of public debt-to-GDP ratios. ‘Debt deflation’ would set in motion a brutal dynamic – the fall in the price level raising the real value of debt. This is the process that did such damage in America’s great depression.

A period of deflation would be tolerable (perhaps even pleasant) if it resulted from greater productivity and rising real incomes for consumers. Unfortunately this does not appear to be the case today. Real wages are falling. There are a number of different types of situation that can occur when prices fall in an economy, with outcomes ranging from the extreme to the more benign:

Chronic or malign deflation is the bogeyman that keeps central bankers awake at night. A deflationary ’death spiral‘ is characterised by a fall in the general price level and aggregate demand. This is the situation that the US found itself in between 1929 and 1933. During the Great Depression, consumer prices fell by a quarter, real gross domestic product dropped 30% and the unemployment rate rose to about 25%.

Benign deflation is different. In Japan it has been harmless (some would argue even beneficial – Japan’s relatively slow growth in recent years being the result of demography rather than deflation). Prices remain fairly static and fall occasionally in a healthy economy, but modest wage increases sustain consumer spending and economic growth.

Price adjustment constitutes a third scenario of falling prices. Here, prices readjust downward for a brief period but, crucially, this neither becomes ingrained nor leads consumers to reckon with consistently falling prices.

Lowflationreading between the lines, it would appear that ‘lowflation’ is a shrewd invention designed to assist the IMF implicitly make the case for raising inflation targets above 2%, which is the established objective in most developed countries. Experience has taught the IMF that this is a highly sensitive subject that needs to be handled with great care. In 2010, Olivier Blanchard, the IMF’s chief economist, broached the idea that central banks should target an inflation rate of 4% to ensure that they have scope to cut interest rates during more difficult times. This recommendation was partly based on analysis by the IMF of the Japanese experience, where the policy rate reached zero in the mid-1990s, prompting a lost decade. However, Blanchard had little chance to explain his rationale – the idea that an inflation rate of 4% could be a policy target for central banks went down like a lead balloon with more orthodox policymakers whose thinking was that low or zero inflation is the appropriate long-run goal for monetary policy. The achievement of low inflation thus raises serious questions about monetary policy.

Monetary policy – the tool box is almost empty

Deflation is a particularly vicious demon when contemplating monetary policy because it prevents a central bank from setting a negative real interest rate – subtracting a negative inflation rate from an interest rate at zero (or near to zero) always gives a positive number. So the central bank’s principal tool of stimulating economic activity – reducing real interest rates (the nominal interest rate minus the rate of inflation) – is rendered inoperative.

The level of real interest rates that balances the amount of savings and investments in an economy with demand is called the equilibrium real rate. There’s much debate (and that’s an understatement) about what the current equilibrium real rate might be. There is however a consensus that it’s fallen. Those economists who believe the world economy faces a long period of sub-par growth (‘secular stagnation’) argue that, with inflation so low, it is impossible to set a nominal interest rate that balances investment and saving with weak demand.

Japan’s experience in battling with deflation and the fact that core inflation in the US remains at 1.5% after three rounds of quantitative easing, suggest that getting rates of inflation to rise will not be straightforward.

What happens next ?

Are we finished?” asked Mr Draghi, rhetorically, during his news conference on 5 June. “The answer is ‘no’. If need be, we aren’t finished here.” The point being that if disinflation continues, the ECB may have to resort to ‘full-blooded’ (i.e. including purchases of sovereign debt) quantitative easing – as the US Federal Reserve and the Bank of England have since the financial crisis.

In June the ECB signalled that it would likely to wait until the end of the year to judge the impact of the measures it unveiled. However economic data published over the summer suggesting the eurozone’s economy had weakened and price pressures had further eased forced the bank to act again. In September Mario Draghi startled markets by announcing a cut in the ECB’s main refinancing rate from 0.15% to 0.05% along with measures to revive lending by pledging to buy hundreds of billions of euros of private sector asset-backed securities and covered bonds (click here for a full analysis of the measures announced by Mario Draghi on 4 September). Mr Draghi paved the way for this new package of measures at the annual meeting of central bankers at Jackson Hole when he recognised that markets had started to doubt in the ECB’s ability to get the inflation rate back to its target of just below 2%.

So having made in September what Mr Draghi himself called “the final rate cut” and having announced the purchasing programmes for ABS and covered bonds, the ECB has now reached the point at which outright purchases of government bonds is the only policy option left. Data released since the start of September suggests that there has been absolutely no let-up in the eurozone’s disinflationary pressures and that the ECB’s policy measures are not, so far, having the desired effect (click here for a comment on the results of the ECB’s first round of loans to banks in the eurozone). And falling oil prices are not going to improve matters, either.

Steve Mann / Shutterstock.com
Andrew C. Craig

Head of Financial Market Analysis & Publications

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