The death of inflation… and how it could revive
The biggest puzzle in the post-financial crisis environment, perhaps the single most important defining characteristic of the “new normal,” is the lack of inflation. If someone had guessed six years ago that major central banks, among them the US Federal Reserve, would have expanded their balance sheets fivefold, he or she would have concluded that inflation rates by now would be running at least in the upper single-digit range.
Yet, today, what we see are overall inflation rates for developed countries averaging well below the 2% threshold that usually defines the monetary policy framework for modern central banks. Moreover, large parts of the Eurozone are battling deflationary pressures. This contradicts a fundamental macroeconomic belief expressed by Milton Friedman: “Inflation is always and everywhere a monetary phenomenon…” Hence “printing” central bank money at the pace of the last six years should have boosted inflation.
Special factors, already present before the financial crisis, can partly explain the situation: globalization, technological progress, greater price transparency worldwide thanks to the internet, and “virtual” goods and services, which are de facto public goods and hence difficult to price in the first place. This is illustrated by the fact that the prices of mass-produced products and services have stagnated or fallen, while exclusive products and services, like healthcare, education, art and luxury, are all experiencing hefty price increases.
Another explanation for the lack of inflation is the fact that many countries are still growing below their potential. Therefore, they have slack in their labor markets and underutilized capital capacities. Wage growth remains subdued for the overwhelming majority of the labor market. However, as in the previous explanation, income for “exclusive” labor - a.k.a. “talent” - is also soaring, contributing to the ongoing inequality debate.
Finally, given the ongoing “North American energy revolution,” gas and oil oversupply has lately lowered energy prices. Oversupply on the food market has done the same thing there. Hence, headline inflation rates have declined more than “core” inflation rates.
However, even accounting for all those factors, the sheer order of magnitude of the central bank’s balance sheet expansion should have affected prices more forcefully than it actually has. So an explanation must be found somewhere else, bringing us back to Friedman’s motto and especially to the word “monetary.” The “money” affecting prices, and to which the great economist is referring, is not the money created by the central bank but the money that, multiplied by the credit system, finds its way into the economy. Moreover, the relation between the economy and “money” is not one-to-one but is in turn affected by how many times money changes hands within a given period.
Hence, the money multiplier and the velocity of money are paramount for understanding the impact money creation by the central bank has on the economy, measured by nominal GDP, and ultimately on prices. Looking at the US, we see that central bank money (or the monetary base) has increased fivefold since 2008, while the money multiplier has decreased roughly by two-thirds, falling from 9 to 3, and the money velocity by roughly 25%, dropping from 2 to 1.5. So the overall impact on the economy of the central bank money is currently one-quarter of what it was before the financial crisis, and a fivefold increase of central bank money will only boost nominal GDP by 25%, which is obviously what has happened in the last six years.
Assuming that this transmission mechanism starts to normalize once the economy itself normalizes means that the Fed will have to carefully reduce the central bank money supply in inverse proportion to the rise of the money multiplier and the velocity of money. What seems in theory an easy task might become quite daunting in reality. This is why we shouldn’t underestimate the inflation threat. It is dead now but might return with a vengeance.