How current economic conditions prevent inflation from being a serious issue in the near future

By Will Rojas

Last Wednesday, former director of the Office of Management and Budget and White House Chief of Staff under the Trump administration Mick Mulvaney described recent government spending as “too much money chasing too few goods” and that current conditions are a “formula for inflation,” calling it “a real threat.” He is not alone in this sentiment. The Bank of America Fund Manager Survey for March found that the greatest perceived “tail risk”—or outlier event—was inflation (37%), topping the pandemic for the first time since February 2020. This survey, comprised of 220 investors holding a total $630 billion in assets, seems to represent an extraordinarily qualified perspective on the economy. However, while testifying before the House Financial Services committee last week, Fed Chairman Jerome Powell projected “the effect [of government stimulus] on inflation will be neither particularly large nor persistent” and that if it starts to rise too much, “we have the tools to deal with that.” Powell’s outlook reflects the chronically low inflation of recent decades, a problem that in itself calls for a solution.

Between 2009 and 2020, inflation as measured by the Consumer Price Index (CPI) reached the Federal Reserve’s 2% target only four times, falling short every other year. When measured using personal consumption expenditures (PCE)—an index containing a wider range of consumer goods that is used by the Federal Open Market Committee—that number shrinks to one. This is true despite the period consisting of the longest economic expansion in U.S. history and near-record low unemployment levels. The trend of persistently low inflation is not unique to the U.S. From 2006 to 2020, the Bank of Japan only hit its target inflation rate (CPI) four times. This significance of this trend can only be understood in light of the effects of chronically low inflation.

The primary reason to be concerned about persistently low inflation is that it offers less of a buffer against deflation. Deflation has a negative impact on the labor market because wages tend to stay the same while prices can move relatively easily. This causes businesses to pay the same amount in wages yet receive less in sales, leading to a lesser demand for labor and possible rise in unemployment. Deflation also makes the real value of debt grow larger over time, making it harder to pay back loans. However, even if deflation does not occur, low rates by themselves are an issue because they decrease the nominal interest rate (real interest rate plus inflation), providing less room for central banks to lower the policy rate in times of financial hardship.  When the pandemic hit, Japan, already targeting a -0.1% rate for short-term debt and a 0% rate for 10-year government bonds, did not have room to lower rates any further. There are several theories that try to explain this, one of which is increasing worker efficiency.

As technology has rapidly advanced in the past several decades, the labor required to create the same product has dwindled. This has led to lower labor costs, allowing for prices of products like TVs to fall by 73% and photographic equipment to fall by 24% between 2010 and 2018. The U.S. Bureau of Labor Statistics found that for non-farm workers, a 3% increase in labor productivity is associated with a reduction in inflation of around 2%. Another theory is centered around shifting demographics. As nations become on average older, they tend to have lower inflation rates. Economists Shigeru Fujita and Ippei Fujiwara argue that as the average age of a population gets older, a larger portion of the workforce is made up of older workers. In an economy where jobs require firm-specific skills, laid off older workers must turn to entry-level jobs, competing with new workers for those jobs and driving down wages, and therefore inflation. According to an analysis by the Federal Reserve Bank of St. Louis, a decrease in young age dependency—ratio of population 0-14 years old to those 15+ years old—and an increase in old age dependency—ratio of population 65+ to those who are younger—accounted for an annual 0.1% decrease in the U.S. inflation rate from 2010-2016. 

One of the more interesting theories for chronically low inflation is Neo-Fisherism. Economist Irving Fisher is known for his theory that nominal interest rates are composed of the real interest rate and expected inflation rate added together. Traditionally, this relationship was thought to show how real interest rate affects expected inflation rate, but a new school of thought has begun which views the expected inflation rate as affecting the nominal interest rate. Under the Neo-Fisherist view, the contemporary environment of perpetually low target interest rates by central banks has created a constant expectation for low rates, which in turn causes them to stay low. The solution to low inflation would then be to actually raise target interest rates and directly counter the expected inflation rate dragging actual inflation rates down. Whatever the cause of low inflation, it remains a more pressing issue than runaway inflation at the moment and, it seems, anytime soon. □

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