Critics of sustained easy monetary policy in the United States often cite the potential for a surge in inflation down the road.
The real problem right now though, according to BofA Merrill Lynch economist Ethan Harris, is actually the opposite – disinflation (positive, but falling inflation rates).
“For central banks,” many of which have a 2 per cent inflation target, says Harris, “this increases the pressure to maintain super-easy monetary policy.”
Most of the central banks across the developed world still aren’t generating enough inflation to hit their targets, even though many have pinned interest rates at or close to zero. The United States, Canada, the euro area, Sweden, Switzerland, Japan, and Norway all find themselves facing this issue (the U.K. and Australia are notable exceptions).
This struggle, says Harris, is behind the “shift to QE — a less predictable and more controversial policy tool.”
(In 2013, a flurry of speeches by Federal Reserve governors expressed concern over the continued trajectory of quantitative easing and what it means for financial stability.)
So, what’s behind the disinflation?
According to Harris, there are three major fundamental drivers of falling inflation rates:
- Economic slack: “In the U.S., the unemployment rate has fallen as many workers abandon the labour market, but it remains above almost any sensible measure of the inflation-neutral rate (NAIRU),” says Harris. “More troubling, the unemployment rate in the Euro area continues to set new records, with no sign of stabilizing.”
- Commodity prices: This is timely in light of yesterday’s brutal sell-off in the commodity complex. Rising commodity prices pushed up consumer price inflation around the world in 2011. “However, commodity prices have been essentially flat for the last two years,” says Harris, “And we expect more of the same going forward.”
- European austerity: Harris says tax hikes from fiscal austerity programs in the euro zone have temporarily boosted inflation, but unless austerity accelerates – and momentum seems to be in the other direction – there isn’t anymore upside. “Many countries in Europe, including France as well as the periphery, need to go through an “internal devaluation” to improve their competitiveness,” says Harris. “That is a polite way to say they need to cut wages and prices.”
Harris also points out that inflation expectations point to higher inflation down the road. This, he says, “reflects strengthening in central bank credibility.”
“However, unless economic actors have complete faith in the powers of the central bank to target inflation, anchored expectations can only slow, not stop, the fundamental drivers of inflation,” writes Harris. “Today, those fundamentals continue to point to falling inflation.”