Do we know what drives inflation?

A few years ago, I recall attending a seminar in which a microeconomist gave a fascinating presentation explaining how supermarkets set prices. The process involved looking at margins and assessing competitors actions in order to set prices sufficiently low as to attract custom but high enough to generate decent revenue. This was followed by a presentation from a macroeconomist outlining the standard macro model of inflation involving inflation expectations, output gaps and employment conditions. The contrast between the two notions was so stark that it was at this point I realised that economists do not fully understand the inflation generation process.

I should qualify this: Obviously, we broadly understand the principles of inflation but in practice we run into difficulties. It is generally believed that inflation is, to quote Milton Friedman, always and everywhere a monetary phenomenon. For obvious historical reasons many German economists, and indeed many elsewhere, still believe that excess monetary creation will lead to a rapid pickup in prices (I recall hearing a prominent monetary economist saying in 2009 how QE would lead to higher inflation within months). However, this model was largely discredited in the Anglo Saxon world during the early 1980s when the naïve quantity theory of money was debunked by the fact that monetary velocity was found to be unstable. In other words, the ratio between GDP and monetary aggregates changed due to the financial deregulation taking place at the time, which reduced the usefulness of monetary targeting as means of controlling inflation.

We should not dismiss monetary theories of inflation completely because, as the German hyperinflation of the 1920s demonstrated, a huge increase in the supply of money will reduce its value. But in the western world over the past eight years we have had one of the most aggressive periods of monetary easing in history without any significant pickup in inflation. Why?

Central banks’ quantitative easing policy which injected huge amounts of liquidity into the economy did not result in a wider spillover into prices because: (i) the liquidity was deposited in a banking system which at the time was not best placed to distribute it more widely throughout the economy; (ii) the liquidity was delivered directly to asset holders who sold bonds to the central bank, and it did not accrue to households and businesses and (iii) there was plenty of spare capacity in economies, with demand muted and the private sector engaged in deleveraging, with the result that we never got into a situation where too much money was chasing too few goods. Thus the conditions for the simple monetarist model of inflation have not held in recent years.

It is also the case that the pre-crisis literature was based on relatively closed economic systems, in which economies would more quickly run into capacity limits. In today’s globalised world that is no longer true, and the rise of China as an economic superpower has hugely increased global productive capacity. As a result, global production costs and prices have been driven down, which has encouraged consumption. Economies such as the US and UK are more likely to experience a rising external deficit as a symptom of excess demand, rather than rising prices as once would have been the case.

The Japanese case is perhaps the most extreme example of an economy which has failed to generate inflation, despite the best efforts of the central bank to get it back towards 2%. The BoJ continues to buy huge quantities of securities, sending its balance sheet to 90% of GDP in the process. No thought has been given to the longer term consequences of this policy, but suffice to say that if the BoJ were forced to run down its balance sheet, the effects on markets would be dramatic. I have long believed that the Japanese policy of trying to push up inflation is misguided in an economy where an ageing population is reliant on its savings. It does seem odd that the central bank is engaged in a policy which has not worked for 16 years and does not appear likely to do so anytime soon. It is probably a measure of desperation that it does not know what else to do. Unfortunately, the higher it drives the balance sheet today, the more difficult will be the process of unwinding it in future – all the more so if it does not generate the desired inflation.

There is not one single reason why inflation remains so muted. I suspect that structural changes are helping to depress inflationary forces – globalisation; the effects of the recession on inflation expectations and the substitution of capital for labour to name but three. Our standard inflation models, in which tight labour markets and excess liquidity creation will lead to higher prices, are currently not working. This is not to say they never will again. It is just that for the foreseeable future, we are going to have to learn to live with lower inflation.

There are pros and cons of such a situation. On the plus side, we will be spared the destabilising effects of a 1970s-style pickup. But it also means that we will find it harder to run down our debt burdens than we have become used to, and that might be one of the reasons why people feel more miserable than they once did. Back in the day, we used to construct misery indices as the sum of unemployment and inflation rates: the higher the index, the more “miserable” we are, but as the chart shows, the UK misery index is near to multi-decade lows. Maybe what we need is a dose of inflation (especially wages). Quite how we can generate that is a matter of much debate.