If the proverbial Martian descended on planet Earth and received a chart of core inflation in the United States or the Eurozone, the last thing that would come to their mind is that the world economy had suffered the most. major financial crisis since the Great Depression and, a few years later, a global pandemic. From 2004 to March 2021, core inflation in the United States and the euro area fluctuated within a narrow range of zero to 2.5%.
The stability of inflation has been impressive – remember the 1970s-1980s? The immediate reaction would be to applaud the success of monetary policy, which would have acted effectively to counter the shocks that have affected the economy. In the same way that a thermostat manages heating or cooling to keep the temperature of a house constant, whether it is cold or hot outside, monetary policy manages interest rates and asset purchases to maintain stable inflation.
But it might not be that simple. Inflation in Japan has been exceedingly low since the mid-1990s, despite repeated attempts to increase it. Inflation in the euro area has been below target for two decades. The Fed has changed its monetary policy strategy precisely to avoid falling into the euro zone’s low inflation trap. The thermostat works, but it can be improved.
Increasing barriers, such as trade tariffs or industrial policies that favor the purchase of national products, is counterproductive, except in very specific cases for geostrategic or national security reasons.
The mysterious stability of inflation is a symmetrical phenomenon. There were times when inflation should have collapsed, such as during the financial crisis. The decline in economic activity in 2008 was much larger than what economic models predicted but, in comparison, inflation barely budged, breaking the relationship between activity and inflation seen before the crisis – and we can conclude from this during the coronavirus crisis. There were also times when inflation rose less than expected – for example, when unemployment in the United States began to fall to levels not seen since the 1960s and inflation barely budged. This has been called “missing deflation”.
There are several possible solutions to the mystery. It is possible that indeed, economic policy has become much more efficient and credible, and that price stability has been achieved in the sense that American economist Alan Greenspan has defined it: a situation in which citizens do not stand. worry more about inflation. If the 2% objective is credible, all economic agents act under this assumption and all behaviors are adjusted almost automatically (wage negotiation, business planning, design of economic policy, everything assumes 2% inflation) so that the goal is achieved. Returning to the example of the thermostat, the relation observed between the external and internal temperatures disappears, since the thermostat adjusts as soon as the external temperature changes. This is an example of Goodhart’s Law, according to which when an economic relationship (for example, the relationship between unemployment and inflation) becomes a policy objective, the relationship is no longer observed in the data – precisely because the economic policy acts in advance and neutralizes it.
The use of monetary policy instruments that go well beyond the ups and downs of interest rates – the detailed communication of central bank intentions, the purchases of public and private assets, the provision of liquidity and even active management of regulatory parameters – have made a fundamental contribution to the credibility of inflation targets. Imagine a world since 2007 without buying bonds or providing liquidity. The economic disaster and the collapse of inflation would have been formidable. And now think about how much these actions were criticized at the time.
The credibility and ambition of monetary policy would explain the stability of inflation. But they are not sufficient to explain the downward bias in inflation over the past decades. Beyond China’s integration into the global economy, a root cause has been globalization and the disintermediation of a growing share of economic activity, which increases competitive pressures and limits the ability to expand. the prices.
The credibility and ambition of monetary policy would explain the stability of inflation. But they are not enough to explain the downward bias in inflation over the past decades.
Think, for example, of taxi services. Until a few years ago, this was a local service, run by a licensing system that created barriers to entry and competed with the local metro, buses and trams. Suddenly, a company appears on the west coast of the United States that is revolutionizing the technology of providing local transportation services. Suddenly, a mobile application represents fierce competition for taxi services around the world. Now extend the example to local distribution of consumer goods, banking, travel agencies, real estate and movies. Any activity susceptible to disintermediation via a mobile application is potentially facing global competition. And it generated a powerful and persistent disinflationary pressure that surprised the economic authorities. In hindsight, it seems that economic policy should have been more expansive.
The solution to this disinflationary pressure is not to erect barriers to limit globalization and disintermediation. After all, it is the process by which productivity and potential growth increase, which are the keys to economic well-being. But it must be taken into account when determining the rest of economic policies. This disinflationary pressure leads to a fall in interest rates and therefore generates budgetary space to design policies, both predistribution and redistribution, which compensate the people affected by this globalization and this disintermediation, reducing the economic inequalities that they generate. The rise in barriers, such as tariffs – still in force in the United States, let us not forget – or industrial policies that favor the purchase of domestic products – such as the Made in America program announced by President Biden – is against -productive, except in very specific cases. for geostrategic or national security reasons.
The global economy is reopening and the different speed of supply and demand recovery is causing upheaval and, in some sectors, temporary price increases. It is not inflation – inflation is a sustained and broad increase in prices, which necessitates increases in nominal wages beyond the growth of inflation expectations, which is highly unlikely with low rates. unemployment still very high. With inflation expectations firmly anchored, the time to control inflation will come once full employment is achieved. Or maybe the mystery will persist and inflation will continue on the path to stability.