The quest for missing inflation

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Nadim Elayan Balagué
May 10th, 2016

In 2016 the United States will have enjoyed six years of positive economic growth and the euro area, lagging behind somewhat in its recovery, will record its third year of growth since the great global economic and financial crisis. However, although both economies are now in an advanced phase of the cycle and in spite of years of ultra-expansionary monetary policy, their respective inflation rates are still anaemic.1 Specifically, in March US inflation stood at 0.9% while in the euro area stood at –0.1%. What is the cause of this lack of dynamism in inflation?

The sharp drop in oil prices (76% between mid-2014 and the beginning of 2016) and in the price of other commodities lies behind a large part of this sluggish inflation. For this reason it is better to look at core inflation, free from the volatility found in the energy and food components. In the US core inflation2 stood at a considerable 1.5% in March but remained below 1% on average during 2014 and 2015, running significantly below the US Federal Reserve 2% target. Similarly, in the euro area core inflation has also remained below 1% on average since the beginning of 2013.

However, before we start studying this lack of dynamism in inflation, it is important to note another particular feature of prices: the fall in the price of crude oil has also pushed down the rates of core inflation. In particular it has lowered the costs of production and transport, pushing down the price of other products (indirect effect). It might also have lowered agents' inflation expectations which, in turn, tends to reduce inflationary pressure (second-round effect).3 By way of example, a change in inflation expectations influences wage negotiations between companies and workers insofar as reductions in inflation expectations promote lower wage rises and consequently less upward pressure on inflation. According to our estimates, these effects are far from trivial. For instance, without indirect and second-round effects, core inflation in the US and euro area would have been 0.4 and 0.3 pps, respectively, above the figures reached in 2014 and 2015 (see the first graph).4

At this point perhaps the most surprising fact is not so much the moderate inflation rates but rather how long they are taking to reach the 2% level. The Phillips curve is the usual theoretical framework used to analyse inflation dynamics, emphasising the negative relationship observed between inflation and the output gap (actual GDP less potential GDP),5 throughout the economic cycle: negative output gaps tend to push down inflation while positive output gaps push it up. The output gap for the advanced economies as a whole was located in negative terrain in 2009 after years of positive gaps and, although the gap has been closing more or less constantly since then, it is still negative. Specifically the euro area is further from closing its output gap than the United States. Undoubtedly this slow recovery in economic activity, particularly in the euro area, explains a large part of inflation's lethargy. In other words, advanced economies have not reached their full productive potential so we should not be surprised that inflationary pressures have yet to emerge (see the second graph).

Nonetheless, we must also take into account the difficulties encountered in measuring potential GDP and therefore the output gap. In fact, the margin of error in estimating this theoretical variable has increased considerably over the last few years given that, due to the strong, prolonged crisis, part of production capacity has become obsolete after years of inactivity. More directly measurable indicators of production capacity such as those related to the labour market show that the production gap is possibly smaller than the one shown by the output gap, so it should have involved greater inflationary pressures.

On the other hand, according to numerous studies inflation's sensitivity to movements in the output gap has steadily diminished over the last few years: for a given output gap, we observe a lower inflation rate. This decreased sensitivity, known as the «flattening of the Phillips curve», is one of the arguments presented in numerous studies to explain why there was no desinflation during the financial crisis of 2008 when the output gaps in the advanced countries fell very quickly to negative terrain («missing desinflation»).

In addition to the problems involved in measuring the output gap, the substantial increase in trade and financial relations between countries, i.e. globalisation, has been put forward as one of the causes for the flattening of the Phillips curve. This phenomenon has helped advanced countries to import an increasing number of goods and services from those with lower production costs, pushing down the final price for their domestic consumers. In other words, using the conceptual framework proposed by the Phillips curve, a country's inflation is increasingly determined by the output gap at a global level instead of by that country's own output gap. However, this explanation, although very intuitive, has not been convincingly validated empirically: some studies support it, especially the one by Borio and Filardo (2007), while others find no clear impact, such as the studies carried out by the IMF and White (2008).6

Lastly, a second factor that seems to be helping to flatten the Philips curve is the greater stability of inflation expectations. Specifically the capacity demonstrated by central banks to keep inflation low and stable has meant that inflation expectations are also more stable. As has been mentioned previously, the very anchoring of inflation expectations ends up making inflation more stable as well. In particular, the long-term inflation expectations of US consumers have remained constant over the last six years at around 2.8% even though the economy has gone from a deep recession to a notable recovery.7

In short, various elements have contributed to the current situation of sluggish inflation but particularly the sharp fall in oil prices, an economic recovery slower than usual, lower inflation sensitivity to economic activity and more anchored inflation expectations thanks to the improved credibility of central banks. However, throughout 2017 we expect inflation to pick up considerably both in the US and the euro area due to the recovery in the price of crude and the further narrowing of output gaps.

Clàudia Canals and Nadim Elayan Balagué

Macroeconomics Unit, Strategic Planning and Research Department, CaixaBank

1. In this Dossier, see the article «A brief history of inflation as a monetary phenomenon» which analyses the growth in the money supply as a key factor in determining long-term inflation.

2. For the US we have used core inflation without owners' equivalent rent as its computation is more similar to the euro area's core inflation.

3. See the Focus «Low inflation: oil and nothing else? in MR03/2016.

4. The indirect effect has probably been more significant because, as mentioned below, inflation expectations have remained relatively stable over the last few years.

5. A negative output gap means there is a surplus of unused production capacity (see the article «Potential GDP, a crucial but unclear concept» in the Dossier of MR05/2013).

6. See, Borio, C. and Filardo, A. (2007) «Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation»; White, W. (2008), «Globalisation and the Determinants of Domestic Inflation», BIS Working Paper No. 250; and the IMF, «World Economic Outlook October 2013» «The dog that didn't bark: has inflation been muzzled or was it just sleeping?», chapter 3.

7. See the article «On the use and abuse of inflation expectations embedded in asset prices» in this Dossier for a broader examination of measurements of a market's inflation expectations. See also the article «Measuring inflation expectations: the devil is in the detail» in the Dossier of MR02/2015.

Nadim Elayan Balagué