Revived price pressure in developed economies has helped lift the spectre of deflation. Yet, the upside risk for inflation seems limited for now. While authorities have successfully developed the tools to fight rising inflation in recent decades, they have proved unable to drive prices higher since the financial crisis, potentially because of insufficient demand in many countries faced with sluggish growth.
INFLATION IS BACK BUT NOT ALL COUNTRIES ARE EQUAL
Most developed economies have seen inflation accelerate since mid-2016, and the International Monetary Fund forecasts 1.7% in 2017 after 0.8% in 20161. However, the increase remains very gradual and conceals significant discrepancies – inflation is still well below central bank targets in the eurozone and Japan, which is encouragement for their monetary authorities to maintain ultra-accommodative policies. Furthermore, the recent rise in inflation has much to do with oil prices, which more than doubled between end January 2016 and January 2017.
Other price measures point to low inflation. The core index – excluding volatile items such as energy and fresh food – remains below 1% year-on-year in the eurozone and around 0% in Japan, although both countries have broken the deflationary spiral.
While inflation can result from higher costs (e.g. during oil shocks and currency depreciations), it only really accelerates when domestic demand exceeds production capacities. When unemployment falls below a certain level, wages tend to rise faster. Similarly, full utilization of production capacities leads to higher prices on goods and services. Of all major developed economies, only the United States and Germany can boast of having almost returned to full employment. In the United Kingdom,it is weakness in sterling that has triggered a pick-up in inflation through import prices. Conversely, in many eurozone countries, high unemployment limits wage pressure, keeping a lid on inflation.
ECONOMIC POLICIES ARE BETTER AT FIGHTING INFLATION THAN DEFLATION OR PRICE STAGNATION
In the 1970s and 1980s, inflation spiralled to a point that it became Public Enemy No. 1. The fight to bring it under control led to the implementation of orthodox monetary policies, greater central bank independence and the end of the indexation of wages on prices. Some believe that all this helped stabilize prices in the 1990s and 2000s, a period dubbed “the Great Moderation” by Ben Bernanke, former chairman of the US Federal Reserve (Fed). However, disinflation probably had more to do with structural global developments such as the computerization of the production process, the declining influence of trade unions, increased outsourcing, growing self-employment and the rising share of China and other emerging countries in global trade.
The low inflation worldwide and more especially in Europe is a reflection of persistent economic imbalances resulting from insufficient demand and activity. Some academics believe that the modest price pressure is due to a period of “secular stagnation” where higher savings and lower investment lead to persistently low levels of interest rates, growth and inflation.
Others are less pessimistic and view this as a temporary phenomenon linked to the severity of the recession and the necessity for economic agents (i.e. companies and households) to improve their financial health through extended deleveraging. It is still too early to say if the current economic recovery will last. There are structural drags (low external competitiveness, insufficient innovation and specialisation, dysfunctional job market) on eurozone growth, with the singular exception of Germany. For the United Kingdom, Brexit is a leap into the unknown that questions the economic strategies of the past thirty years.
In Japan, the central bank has managed to end two decades of deflation through ultra-accommodative policies. But victory remains uncertain – deflation may return if authorities cannot revive an economy that suffers from a collapse in demography and weak domestic consumption.
Meanwhile, the United States seem to be faring better, with continued economic improvement and stimulus through significant infrastructure spending could provide long-term support to growth. However, the rejection or renegotiation of existing trade agreements could lead to weaker growth and higher inflation in the United States and worldwide.
Inflation in advanced and emerging countries
Inflation is often considered by monetary policy theorists as a consequence of excess money supply. However, the past decade has shown that it is insufficient demand that leads to continuous deflation. Only the emergence of policies combining economic support and structural reforms could help end the sluggishness that remains a threat for our economies.