The Lowflation Demon That Vexes Central Banks

Persistently low inflation, or “lowflation,” is vexing lots of people. According to the recent minutes of policy meetings of the Federal Reserve and the European Central Bank, central banks on both sides of the Atlantic have been trying to identify the causes — but with limited success so far. This complicates monetary policy decisions and undermines the range of institutional solutions that have been proposed by academics. Until this changes, central banks may need to think more holistically about the objectives of monetary policy, including the unintended consequences for future financial stability and growth of being too loose for too long.

Four facts stand out in reviewing recent inflation data:
Inflation rates have been unusually and persistently low.
This is primarily an advanced-country phenomenon.
Inflation has not responded to the prolonged pursuit of ultra-low interest rates and huge injections of liquidity by central banks through quantitative easing. 

This has coincided with a period of notable job creation, especially in the U.S., thereby flattening the “Phillips curve” that plots unemployment and inflation rates.
Many economists worry that such lowflation frustrates the relative price adjustments that are critical to a well-functioning market economy. And if the inflation rate, and related inflationary expectations, flirt with the zero line for too long (as had occurred in Europe), there is an increased risk of actual price declines that encourages consumers to postpone their purchases, weakens economic growth, and undermines policy effectiveness (as had been the case in Japan).

The many reasons that have been put forward for the lowflation phenomenon range from benign measurement errors to worrisome structural drivers, with a host of “idiosyncratic factors” in the middle. Indeed, the Fed minutes released last week contain a list of possible drivers. These also note that a few central bankers are questioning the usefulness of traditional models and approaches in explaining and predicting inflation behavior. The recent ECB minutes also refer to “a number of explanatory factors” for lowflation and the importance of monitoring “the extent to which such factors could be transient or more permanent.” (And that is not the only issue vexing central bankers and economists more generally — productivity and wage formation have also been puzzles to an unusual extent.)

Turning to solutions, some economists have suggested that central banks increase their inflation targets, typically set at 2 percent currently. Others have proposed that the monetary authorities should pursue a price level target so that shortfalls in meeting the desired inflation rate in one year would require aiming for a higher rate in the subsequent year.

As attractive as they may sound to some, these solutions are operationally challenged, particularly if structural factors are depressing inflation. 

Having failed to meet the 2 percent target despite aggressive monetary policy, it is far from obvious that central banks would be able to meet a higher objective. And no one is quite sure how the political system would respond to a central bank that pursues much higher inflation as it tries to offset the shortfalls of prior years. Indeed, until we have a better understanding of how the transmission mechanism has evolved, there is no guarantee that a change in policy approach would do anything more than threaten even greater collateral damage and unintended consequences.

Already, economies on both side of the Atlantic must contend with the risk that a loose monetary policy approach may have overly repressed financial volatility, excessively boosted a range of asset prices beyond what is warranted by economic fundamentals, and encouraged too much risk-taking by non-banks. Indeed, in the Fed minutes, the central bank staff noted that “since the April assessment, vulnerabilities associated with asset valuation pressures had edged up from notable to elevated.” Robust job creation, financial conditions, and the overall health of the economy should guide monetary policy formation rather than the excessive pursuit of a still-misunderstood lowflation.

The lowflation demon is real and, in the case of the U.S., the market now believes that it will likely dissuade the Fed from delivering on the next signaled step in the gradual normalization of monetary policy, including an interest rate hike in the remainder of 2017. Yet a lot more work is needed to understand the causes and consequences of persistently low inflation. Until that happens, central bankers may be well advised to stick with the demon they know rather than end up with one of future financial instability that undermines prospects for growth and prosperity.

by Mohamed A. El-Erian
‎August‎ ‎23‎, ‎2017‎