The Death Of Inflation Has Made Central Banks Victims Of Their Own Success

Central banks in the rich world may have been too successful in subduing price pressures

IT TOOK an iron will (and a handbag) to beat the inflation of the 1970s. Under Margaret Thatcher the British government squeezed the economy with high interest rates until the beast submitted. The Federal Reserve, then led by Paul Volcker, followed suit. Such displays of fortitude convinced markets that governments were serious about keeping inflation low. Expectations of future price increases converged around central-bank targets, touching off an era of long expansions and mild recessions. Yet relative price stability may now be adding to the rich world’s economic woes.

Deep recessions like the recent global contraction would normally be expected to send inflation tumbling. Workless labourers ought to reduce wage demands to find employment; firms with unsold goods should slash prices to clear inventories. There was every reason to expect that inflation would go to zero or even enter negative territory in recent years. In April 2009 the International Monetary Fund forecast that inflation in that year would be -0.2% for advanced economies. Instead it has barely budged across the latest business cycle (see left-hand chart).

Deflation has been the "dog that didn’t bark", notes the IMF in its new "World Economic Outlook"*. When America’s unemployment rate jumped between 1980 and 1982, by 4.5 percentage points to 10.8%, core inflation plummeted from 12.0% to 4.5%. The jobless rate in America rose even more steeply between 2007 and 2009 but inflation dropped by less than one percentage point, from about 2.4% to 1.7%. Where inflation rates rose above central bankers’ targets, as in Britain, or below them, as in Japan, expectations of future rates still stayed close to the targets.

Some economists argue that stable inflation is a result of some big changes in the labour market. Wages and prices did not fall by much in recent years because jobless workers exited the labour force for good--a result of over-generous welfare benefits and obsolete skills. Such people do not compete with others for jobs and therefore cannot drag down inflation.

Another view is that stability reflects central banks’ credibility. When central banks whipped inflation in the early 1980s and adopted low targets for it, they firmly anchored beliefs about future growth in prices and wages. This credibility is self-reinforcing. Workers who expect prices to rise only slowly tend not to push as hard for higher wages. That helps firms to keep costs and prices down. When the crisis struck, this process also helped avert deflation. If prices are not expected to drop, workers are less likely to accept wage cuts. Anticipating stable wage demands, employers are more reluctant to cut prices.

This second story seems a better fit for the data, argues the IMF. Since 1990 expected rates of inflation have inched ever closer to central-bank targets. And over the same period short-term gaps between actual inflation and the official target had ever weaker effects on people’s expectations. Markets seem to trust central banks to return inflation to target, and that trust itself helps keep it in line (though the dispersion in expected inflation rates seems to have widened lately).

As inflation has become more anchored, its links with other economic indicators have weakened. In a study of 21 rich countries since the 1960s, the IMF shows that changes in unemployment now influence inflation much less than in the past (see right-hand chart). Without the breakdown in this relationship, America’s economy would have faced deflation rates approaching 3% in the wake of the recent recession, the IMF notes.

That is small comfort to inflation hawks, who fear that expectations may well prove less anchored during the next boom. After all, firms could easily be more enthusiastic about raising prices than cutting them. Yet experience before the financial crisis suggests that boom times may not be so different. In the decade before the crisis unemployment in Britain, Ireland and Spain dipped below its estimated "natural rate" (the lowest sustainable rate) for years at a time. Actual inflation and expectations of it hardly budged.

What could cause inflation expectations to break free again, as in the 1970s? Contrasting the experience of the American and German economies, the IMF reckons that central-bank independence makes all the difference. Both the Federal Reserve and the Bundesbank mistakenly saw 1970s-era unemployment as mostly temporary. But the Bundesbank managed to resist its government’s calls for looser monetary policy. The Fed, under its then chairman, Arthur Burns, was more responsive to Richard Nixon’s demands. Only in the late 1970s, when public opinion no longer saw unemployment but inflation as the chief economic evil, was it politically possible to give the Fed licence to stamp out inflation.

Missing the target

Low inflation may be central bankers’ proudest achievement but it comes with its own set of economic risks, argues the IMF. The economic stability of the pre-crisis era may have fuelled the excess borrowing that led to the financial crisis. And a 2012 IMF working paper suggests that reining in inflation can increase income inequality by compressing wages while allowing asset prices to soar.

More worryingly, the weakening link between inflation and unemployment could breed complacency about rising joblessness. Central bankers weaned on tales from the 1930s and 1980s, when soaring unemployment produced tumbling inflation, may have underestimated recent economic troubles because of stable inflation. An outbreak of deflation might have prompted them to act sooner and even more resolutely to battle the recession. Central banks are victims of their own success. With inflation no longer a reliable indicator of demand, they must look elsewhere to keep economies from running hot or cold.

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