Will the virus kill off what's left of inflation?

For many years, central banks’ biggest challenge was convincing markets that they could keep inflation under control. Today they face the opposite problem: getting inflation back up to where it should be. Major central banks – including the Federal Reserve, the Bank of England and the European Central Bank – generally consider this to be an annual rate of 2%.

The fact that inflation remained so low, after the longest economic expansion on record, already had central bankers perplexed. The question has now taken on a new urgency as markets grapple with the twin shocks of the coronavirus pandemic and an oil price collapse, set in train in March. US bond markets are now pricing in the lowest level of inflation since the financial crisis of 2008-09, when investors were seriously worried about the risk of deflation (where prices within an economy fall).

The steep fall in the oil price will unquestionably put pressure on prices  globally. At the start of the year, investors briefly worried about the inflationary impact of an oil price spike following the assassination of an Iranian general. Just a few months later, they are worrying about a very different kind of oil shock, with the collapse in energy prices already depressing overall inflation.

The impact of the coronavirus is more complex. When the virus was contained to China, there was some concern it would act as a supply shock that drove prices higher. The cost of certain technology components, for instance, rose sharply as supply chains were shut down. However, as the epidemic has morphed into a pandemic, it is now looking far more likely that it will prove to be a demand shock, with changes to business and consumer behaviour reducing demand and prices.

Even before these shocks, inflation was not behaving as expected. Economic theory tells us that when the jobs market is very strong – as it was in the US and UK – inflation should be high. And yet “core” US inflation, which strips out the impact of volatile food and energy prices, ended 2019 at a very modest 1.5%.

Over the last few years, it has only reached the Federal Reserve’s target of 2% on a handfull of occasions. The mystery is how this happened as US unemployment fell to just 3.5%, the lowest level in 50 years. The question is even more acute for the European Central Bank, which has
consistently undershot its target even more dramatically for the past few years.

US inflation persistently below target since 2009

^{Source: Federal Reserve Bank of St. Louis}

Why does it matter?

Central bankers’ big worry is that low inflation makes it much more difficult to effectively use monetary policy to achieve their objectives. There are two reasons for this.

Firstly, low inflation means that “real” interest rates are higher than they might otherwise be. A real interest rate reflects an adjustment for inflation. If you borrow money at a fixed interest rate, you worry less about the interest bill if you know that your revenue or earnings will be rising at a healthy pace. In other words, inflation reduces the burden of debt. Low inflation can be problematic in a world awash with debt.

Secondly, at low levels of inflation there is a greater risk that a slowdown or shock will move an economy into deflation. And with prices falling, economic growth can shudder to a halt. Central banks seek to minimise this risk by keeping interest rates at very low levels to stimulate the economy and raise inflation. Yet this has drawbacks. As former Fed Chair Janet Yellen explained in 2017, “sustained low inflation…is undesirable because, among other things, it generally leads to low settings of the federal funds rate in normal times, thereby providing less scope to ease monetary policy to fight recessions”.

When Yellen made those comments, many investors probably shrugged them off as a theoretical concern. With markets now increasingly worried about the risk of a global downturn, they are of much greater concern. The Federal Reserve has cut rates to zero, while the ECB and Bank of Japan already have interest rates in negative territory. The worry that central banks were “running out of bullets” is undoubtedly one reason why rate cuts did so little to calm markets.

Central bankers insist that they can use unconventional policy to stimulate the economy when rates are at very low levels. However, we have seen that these policies are hard to unwind and can have unintended consequences. In the eurozone, for instance, the policy of negative interest rates is having a very detrimental effect on the profitability of the banking industry.

Where next?

There were signs that inflation was making a modest recovery in the US. Tight labour markets pushed wage growth up to 3%, which could have started to lead to more generalised inflationary pressure through the economy.

Coronavirus and the oil price fall will certainly delay this. Even before Saudi Arabia’s surprise production increase, lower energy prices were having an impact on inflation. For instance, an index of prices paid by US producers fell by 0.6 percentage points in February, the steepest drop in five years. The oil price fall will also have a sharp impact on the US jobs market, limiting the scope for wage increases. Some indebted oil companies face the risk of bankruptcy, while many more will have to scale back operations.

Central bankers’ consistent failure to meet their inflation targets in recent years is a challenge to their credibility. The Fed and ECB have both said for several years that inflation would rise towards 2% – but the target has remained elusive. It is only when markets are in the midst of a crisis, as is now the case, that we realise how important that credibility is.

Long-term drivers of low inflation

There are various theories about some of the long-term forces that have been depressing inflation in recent years. The key factors include globalisation, technology and the “natural” rate of interest.

Globalisation has probably had a dampening effect on price rises. Global markets in manufactured goods are very competitive, limiting companies’ ability to raise prices. This keeps a lid on price rises throughout the economy.

Evidence for this theory is seen in the fact that there is a significantly higher rate of inflation for services than goods (see chart). A new TV can come from any number of different countries; for a haircut or legal advice, you have to stay closer to home and pay a local price.

Eurozone inflation is higher for services than for manufactured goods

^{Source: Eurostat}

Technology may also be having an impact. Companies with new and disruptive business models are providing a wide range of goods and services at much lower cost than ever before. For companies like Amazon and Uber, growing market share through aggressive pricing of goods and services is a key part of their strategy. Technology has also provided consumers with much more price transparency, again limiting companies’ ability to raise prices.

There is also a less obvious way in which technology impacts measures of inflation. Today’s smartphones may cost more than they used to – but they are also so much more powerful than they used to be. Economists adjust their price measurements to allow for these technological advances. In simple terms, the price of a smartphone would have to rise by a greater amount than the value of its increased capabilities for there to be any inflationary impact.  Some areas of technology have moved so far and fast that they could be having a deflationary impact.

More theoretically, central bankers think low inflation could be a result of a fall in what they refer to as the “natural” rate of interest. This is the interest rate at which monetary policy neither stimulates nor restrains an economy. It is determined by many factors, with demographics perhaps the key one. It is thought to have been trending downwards for many years. The problem is that the natural rate is a figure that can't actually be observed in real time. It can only be estimated and is therefore an inherently uncertain figure. As a result, it is possible that the natural rate of interest is actually lower than previously thought. This would mean that – relative to the natural rate – “low” interest rates might not be as low as we believed.