Imagining a “Post-Inflation” World

Across most of the leading advanced economies, inflation is running well below the rates targeted by central banks. In the United States, the principal inflation measure tracked by the Federal Reserve sits at barely 1%, despite an expanding economy and a rapidly tightening labour market. In Japan and the Eurozone, central banks have set policy interest rates at zero and are aggressively pumping money into the economy to avoid deflation – defined as a generalized drop in the price level. In both the UK and Canada, the short-term policy interest rates directly controlled by central banks remain near all-time lows. Almost everywhere, financial markets seem to be heavily discounting the prospect of higher inflation. As Bank of England Governor Mark Carney recently observed, even today, some six years after the 2008-09 financial crash, “there are profound secular and cyclical disinflationary forces at work in the global economy.”[1]

The outlook for inflation came to mind after I read a short paper by economist Alice Rivlin, who previously served as a senior official in the US government and at the Federal Reserve Board.[2] She poses two provocative questions. Why do policy-makers continue to focus on “fighting inflation” as a primary macroeconomic challenge, when upward pressure on consumer prices has been largely absent in the Western world for more than half a decade? And does inflation still deserve to be treated as a significant threat to long-term economic well-being?

Rivlin’s questions are timely, albeit rarely addressed by policy-makers or mainstream economic commentators.

Looking ahead, why might it make sense to worry less about the risk of escalating costs and prices across multiple markets for goods, services, labour, and raw materials – i.e., about inflation? There are a few reasons.

One is an expectation of persistent slower growth in most of the advanced economies, coupled with a diminution in projected growth for the world economy as a whole. It is striking that published forecasts from central banks, international agencies, and private sector organizations such as the McKinsey Global Institute all point in the same direction: the rate of economic growth, both globally and in the Western economies, will diminish in the coming decades, compared to the 60-year period that ended with the 2008-09 global slump. Population aging and declining labour force growth are key factors in such assessments. In a sluggish growth environment, aggregate demand is less likely to bump up against supply constraints – the situation that typically leads to higher inflation. This is doubly true given ongoing advances in technology which are adding to supply capacity in many industries.

A second reason why inflation is likely to be lower in the future than in the past lies in the burgeoning ranks of retirees. As people approach and then enter into retirement, many naturally fear outliving their “nest eggs.” This is especially the case in countries like Canada and the United States, where dwindling proportions of the population have access to defined benefit pensions. Inflation arguably is the biggest risk to the economic comfort of retired households. A rising fraction of non-working seniors means that voters will tend to put more pressure on governments to keep inflation as low as possible. In Western democracies, older age cohorts already exercise disproportionate political sway, and their clout will only increase as they become a bigger force within the overall voting-age population. Stated differently, the political constituency for very low inflation is large and is set to grow over time. This suggests that a scenario of accelerating inflation is becoming less probable on political-economy grounds in many countries.

A third reason why inflation rates have downshifted and may well stay unusually low is the waning market power of “labour.” Economists have found that the share of national income accruing to workers has fallen in many countries – particularly since the 1980s.[3] Weaker unions and the greater role of imported goods and services in national economies are part of the explanation, but more important factors are the impact of technological innovation and the declining real cost of “capital” – trends that are prompting huge numbers of firms to replace labour with machines and technology. To the extent that workers collectively have less bargaining power, the prospect of “cost-push” inflation driven by rising wages becomes increasingly remote. Wage pressures have been notably muted in the United States, even as America’s economy has steadily expanded and the unemployment rate has dropped back to the 5% range.

Financial markets in most Western countries continue to anticipate lower-for-longer interest rates. Such a view is consistent with, and at least in part reflects, a future in which inflation trends below the levels seen in previous economic cycles. As we approach the last few months of 2015, the most pressing economic worry for central bankers and Finance Ministers is not how to contain inflation today or tomorrow, but rather what can be done to achieve even a moderate pace of economic growth over the medium term.