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By Andrew Kenningham, Capital Economics
The world economy has been performing well but, contrary to the rules of economics, inflation has been low. Andrew Kenningham explains why it may stay low for a while, and how this leaves policymakers and households with a dilemma.
Much has happened since the global financial crisis (GFC) nearly a decade ago: a deep recession, a banking crisis, a huge rise in unemployment, an increase in public sector deficits, and threats to the survival of the eurozone.
However, the world economy is now largely back to normal. Government deficits have fallen, the banks have been rescued and, Greece apart, even the eurozone seems to be in good shape.
Perhaps the most encouraging development is that the unemployment rate in many countries has fallen to its lowest level for several decades. In the UK and US, it’s just 4.5 per cent; in Germany it’s 4 per cent, and in Japan it’s below 3 per cent.
Inflation still low
However, one thing that isn’t back to normal is inflation.
Admittedly, the threat of outright deflation has faded. But prices in the major advanced economies rose by less than 1 per cent last year, and they look set to rise by only about 1.5 per cent this year and the next. This is despite central bankers printing a whopping US$10 trillion since 2009.
So why has inflation remained so low? Two rather different explanations have surfaced.
1. Still a lot of hidden unemployment…
The most common explanation, which fits most easily with conventional economics textbooks, is that the world economy is not as healthy as it appears.
Some evidence supports this view. For example, despite the low official unemployment rates, many people are working fewer hours than they would like, and others have given up looking for work.
It’s also possible that unemployment could fall to lower levels than in the past, before generating much inflation.
The increased uptake of higher education may have reduced the number of people who are ‘unemployable’. Use of the internet to advertise and search for jobs may have made it easier to match vacant positions with people. And changes in policy have increased incentives to work.
If this explanation is correct, unemployment may continue to fall, and we can hope for a year or two more of strong growth. But eventually inflation should start to pick up.
2. …Or is inflation now a thing of the past?
The other more intriguing explanation is that inflation has been killed off indefinitely by several fundamental changes.
It’s well known that the bargaining power of labour has been reduced because trade union membership has declined, technology has displaced people in many occupations, and globalisation has allowed employers to shift jobs overseas. What’s more, modern service-sector companies, such as Facebook or Amazon, can expand their turnover without taking on many additional workers.
Other developments in the labour market have also reduced upward pressure on wages.
In the US, the proportion of employees who don’t have permanent contracts has increased from around 10 per cent in 2010 to 16 per cent today. This includes musicians who perform the occasional gig and numerous independent consultants and freelancers. In addition, more people are on zero-hours contracts.
These workers are less able to push for wage rises than full-time, trade union members working in traditional industrial occupations.
Dilemma for policymakers
It’s possible, therefore, that we’re now living in a low-inflation world. So, why would that matter?
It would create a dilemma for policymakers. Central bankers have almost universally been puzzled by the combination of strong economic growth and sluggish inflation.
They’re wary of tightening monetary policy, because this could kill off the recovery. But they don’t want to keep interest rates too low, because that could fuel excessive risky lending and feed asset-price bubbles.
Dilemma for households
Inflation also matters for ordinary citizens and it creates a dilemma for households.
If inflation does pick up, central bankers would raise interest rates and this in turn would push up the cost of mortgage payments and increase returns on bank deposits.
It could also lead to falling bond prices or trigger a slump in property and equity prices. In these circumstances, households should be cautious about both borrowing and investing. You might want to keep your money in the bank.
On the other hand, if inflation remains low indefinitely, mortgage rates will also stay low and there’s a greater chance that asset prices – be those bonds, property, or equities – will remain high, by historical standards.
In these circumstances, the biggest risk for individuals is being too cautious and missing out on the gains to be had from investing in property or financial assets.