Last month, when U.S. President Donald Trump urged the Federal Reserve to cut interest rates, he said “there’s no inflation.” We don’t need a fact-checker to tell us that inflation in the U.S. isn’t non-existent. However, it is true that the current tepid level of inflation does not meet many economists’ expectations, against the backdrop that the U.S. economy is growing continuously with a tight labour market.
The Fed’s preferred measure of inflation, the Personal Consumption Expenditure (PCE) Price Index rose 1.5% in March 2019 from a year earlier; the closely followed “core” inflation rate, which strips out volatile food and energy prices, fell to 1.6% in March from 1.7% in February.
As for the eurozone, core inflation fell to 0.8% in March, its lowest level in two years, from 1% in February.
Right after the global financial crisis in 2008, major central banks such as the Fed and the European Central Bank (ECB) reduced interest rates to ultra-low levels, and even to negative territory for the Bank of Japan (BOJ). As interest rates were already so low, they did something unconventional – printing money to buy assets in the financial market directly on a massive scale, in an attempt to lower borrowing costs and eventually boost economic growth by encouraging more consumption and business investment. The stimulus was expected to bring inflation from negative or very low levels back to “targets.”
The Fed considers a 2% inflation most consistent over the longer run with its statuary mandate, while the ECB aims to maintain inflation rates below, but close to, 2% over the medium term. The BOJ set the “price stability target” at 2% in January 2013, and has made a commitment to achieving this target at the earliest possible time. Meanwhile, China set its consumer inflation target at “around 3%” during the annual parliamentary session in March this year.
In any case, a stable, not too high and not too low inflation seems to be considered essential to healthy economic growth by most policymakers, as it incentivizes people to buy sooner, thereby stimulating the economy as a whole. Employees should love it too – when inflation increases, wage growth tends to follow.
Inflation is also welcomed and desperately wanted by many debt-ridden governments and borrowers following the financial crisis, because it has an effect of reducing the real value of the debts that need to be repaid. On the other hand, if prices are falling, consumers will delay making major purchases as long as possible. That means less economic activity.
Very low inflation is not desirable and is typically associated with weakness in the economy. It generally leads to low settings of interest rates by central banks, thereby providing less room to ease monetary policies to cope with the next economic downturn.
In the aftermath of the financial crisis, the Fed reduced the Federal Funds Rate from 5.25% in September 2007 to almost zero in December 2008. With the current target rates set at 2.25-2.5%, the Fed has less room to manoeuvre, if the lower bound is zero.
In this context, it is worrisome to see that many advanced economies are apparently being trapped in a low-inflation environment and struggling to meet their inflation targets on a consistent basis, despite the trillions of dollar pumped into the financial market by their central banks over the past decade.
Central banks may easily lose their creditability built over the years if people are not convinced that the price levels can reach the target. In a press conference on 20 March, Fed Chairman Jerome Powell stated that low inflation is “one of the major challenges of our time.”
Take the U.S. as an example. Tight labour markets and low unemployment rates have historically translated into higher inflation. This is what the Phillips Curve tells us – inflation and unemployment have an inverse relationship. However, this relationship may now have broken, or at least weakened. With the U.S. unemployment rate hovering near a 50-year low at 3.8% in March 2019, inflation remains relatively modest.
Fifty years ago when the unemployment rate was as low as the current level, PCE inflation was around 4.5%. The recent inversion of the yield curve, albeit temporary, suggests that markets are anticipating subdued inflation in the years ahead.
I suspect one important explanation for the low inflation observed in many advanced economies is the structural shift in the economy. A more connected world and a globalized market have given consumers more choice and transparency on prices than decades ago.
The rise of e-commerce and online shopping are likely to have a disinflationary effect as shops, both bricks-and-mortar and online, need to lower margins in order to compete with both domestic and foreign market players. Online retailers are also able to lower prices more readily as they can save costs by not running physical stores.
Back to the case of the U.S., the “Amazon effect” cannot explain the full picture of the persistently low inflation. Other possible reasons are the emergence of the “sharing economy” which utilizes goods and services that are otherwise idle, and that the labour market might not be as strong as it appears to be.
Should inflation in the U.S. remains below target consistently, the Fed would maintain interest rates at the current level for a longer time. It has already signalled that there would be no rate hikes for the rest of 2019 and decided to stop the unwinding of its balance sheet in September. The Fed is not alone, as the ECB is likely to delay its interest rate hikes as well.
This inevitably limits room for many advanced economies to ease monetary policies to fight the next downturn, and their governments would instead need to rely more on fiscal stimulus. However, this will not be easy due to the accumulation of public debts in many countries (Figure 1).
Hong Kong’s policymakers should spend and use its fiscal reserves more wisely to prepare for the rainy days. Technological changes and structural shifts in the global economy may have altered some economic relationships that were empirically proven in the past. There are more views that the traditional measures of GDP and inflation are no longer sufficient to reflect the true state of the economy. Accordingly, officials in Tamar may need to revise their old recipe to deal with economic and social problems in the future.