Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 5 March 2015

Deflation, inflation, oil prices and asymmetries

When both headline and core inflation rose above target after the financial crisis, helped by rising oil prices, the Fed and Bank of England kept their nerve and did not raise interest rates. They saw through what was a temporary episode. The ECB’s judgement was not as good. Even in the UK it was close, with three out of nine MPC members voting for a rate increase for a few months. But it was the outcome that mattered - excess inflation was ignored because it was temporary. To what extent is what we are seeing right now just the mirror image of this period?

In terms of where inflation is and the monetary policy response, the situation today does indeed look like a mirror image. Headline inflation is or is about to be negative, and core inflation has fallen below target. As Tim Duy points out for the US, core inflation seems to be heading lower rather than returning to target. However I think that is where the symmetry ends. While the dangers of letting inflation rise above target because of temporary shocks are small, the dangers in the opposite direction are more serious. 

One of the arguments used by the inflation hawks when oil prices were high is that even if the impact of higher oil prices on inflation was itself temporary, there was a danger that inflation expectations would increase, and the central bank would lose its anti-inflation credibility. My response at the time was three-fold: first, the private sector can see the reason that rates are not being raised (the continuing recession), so credibility should not be in danger; second, the best indication that the expectations that matter have shifted is when nominal wage inflation starts to pick up (which it did not), and third when that happens it will be easy to restore credibility and reduce expectations by raising rates. [1]

None of these arguments apply with deflation today. Then unemployment was clearly too high. Today unemployment is not clearly too low. How far we are from the natural rate is unclear, but no one would argue that we are in a boom that is the mirror image of the recession a few years ago. The second argument is that we could use changes in nominal wages as a clear indicator that the inflation expectations that mattered had shifted. That argument is not symmetrical because of the well known resistance to nominal wage cuts. Finally if credibility does seem about to be lost, the central bank will find it very difficult to take action to restore it because of the Zero Lower Bound (ZLB).

Please allow me to get technical for just one paragraph, which can be safely skipped. As has often been pointed out, the ZLB means that there are two steady states in the economy associated with a given real interest rate: the ‘intended’ equilibrium with target inflation, and the ‘ZLB equilibrium’ when inflation is negative. I recently discussed a paper that treated agents views about which equilibrium was appropriate as a ‘belief’ and that perhaps the liquidity trap could be a manifestation that agents believed we were heading for the ZLB steady state. The controversial aspect of this analysis is the suggestion that this belief could be shifted by the monetary authorities raising rates. I find that very unconvincing, but it would be a mistake to dismiss the exercise completely on that account. In that post I did suggest an alternative rationalisation for why we might be heading for the ZLB equilibrium: agents no longer believed that the monetary authority had the means to stop it happening.

This last asymmetry is the one that troubles me the most, and why I am not as relaxed as monetary policy makers appear to be about deflation. There are three interpretations of this relaxed attitude to negative headline inflation. The first is the one I suspect monetary policy makers actually hold, which is that the beneficial impact of lower prices on demand will with a year or so push inflation back to target, so there is no reason for concern. [2] I think the probability is that they are correct, but good policy does not just think about the most likely outcome, but should also be robust to risks, particularly risks with large consequences.

The second interpretation that the private sector could give for the relaxed attitude by central banks in the US and UK is that deviations above and below 2% are not treated symmetrically. In theory this should be more of a concern in the US than the UK, because in the UK asymmetry is against the central bank’s mandate. However I’m not sure the private sector thinks that is as important as MPC members do. There is one obvious additional asymmetry between now and a few years ago: many of those calling for higher rates back then are still pushing for higher rates today.

The third interpretation about why central banks are doing nothing is there is nothing they can do. Quantitative Easing seems to have come to a permanent halt either because it has stopped having a useful effect, or because policy makers fear it is having undesirable consequences. Under this interpretation the inflation target loses credibility not because the private sector no longer believes policy makers’ stated objectives, but because they no longer believe they have the means to achieve them. 

This possibility is the one that should really be worrying central banks right now. It is a scenario that is quite consistent with what is currently happening, and it puts at risk central bank credibility in a most fundamental way. Quite simply, central bank credibility is destroyed because people believe they have lost the ability (rather than the will) to do their job, and there is very little central banks can do to get it back because of the ZLB. This is what should be giving central banks nightmares. Strangely, however, they seem to be sleeping just fine.

[1] A footnote for macroeconomists: this is why I have never been convinced by Cochrane’s worries about using the inflation target as a transversality condition.

[2] Resistance to nominal wage cuts may also dampen any the deflationary path, giving time for these positive effects to come through. However resistance to nominal wage cuts does not mean the ZLB equilibrium will never occur – in the paper I discuss in this post, it is the reason why that equilibrium is associated with high unemployment.



  1. I wonder in how far the collapse of oil prices is trickling into core inflation. Oil is so important to everything (transportation, plastics, energy) that I think that core inflation doesn't completely filter out the recent oil price regime change. However, the unexpected price change is a positive shock to demand and a boost to real wages, so a continued solidification of the deflationary regime (and thus the ZLB equilibrium) will be even more puzzling. In fact, in this case, I believe that unemployment cannot be too low (and in normative terms, I cannot imagine the cirumcstances where this could ever be the case in a relatively free market economy).
    If deflation continues to spread there will be two possible explanations: Either we have entered a different stage of world economics similar to the deflationary period from 1873-1896, or the power of supply-side stimulus in targeting inflation has to be reconsidered in the sense that the monetary base, the interest rate level, asset price developments and the unemployment rate alone are not sufficient indicators of future inflation and demand-side indicators like real wage changes (the Yellen charts) or median household net worth changes should receive more attention.

  2. I reread Andrew Sentance writing for the Daily Telegraph 04 Aug 2012 'Fall in inflation offers brief moment of respite' when Krugman mentioned recently he was still at it. He said then:

    "The MPC has not behaved as a group which wanted to embrace low inflation. Rather, it has worried about the prospect of deflation – which now appears a remote possibility for the UK – and has taken measures that have added to the UK’s recent inflation problems. In 2008-09, the MPC was quite right to cut interest rates dramatically and inject money through its programme of Quantitative Easing, which helped stabilise the economy and financial system after the collapse of Lehman’s. But since then, the Committee appears to have been happy to accommodate inflation rather than resist it. The MPC did not take the opportunity to raise interest rates in late 2010 and early 2011, despite support from a third of the committee (Spencer Dale, Martin Weale and myself). And more recently, the MPC has gone back to the monetary pump with additional QE, in the belief that this would support economic growth. It hasn’t worked, and one of the risks attached to this policy is that it results in more inflation over the longer term. In last week’s column, I argued that a serious health warning was needed in reading the latest GDP figures. Now I am applying a similar health warning to the Bank’s Inflation Report"

  3. "Quite simply, central bank credibility is destroyed because people believe they have lost the ability (rather than the will) to do their job, and there is very little central banks can do to get it back because of the ZLB. "

    People believe it won't do its job (either because it lost it's will or lost the ability). They're pricing in lower inflation. Likewise they don't believe fiscal policy will come to the rescue. Fiscal policy definitely hasn't lost its ability, nor has monetary policy. The U.S. Fed could pull a Japan and say we'll hit 3 percent inflation if they wanted to.

    But a Republican Congress is having hearing to limit their independence and so the Fed is cowed. Appointing good people to the FOMC wasn't a priority for Obama, either.

  4. I reckon we should take "monetary policy" off the socio-economic platform for a five year experiment, if not ten. The overnight (cash) rate of interest should be set to zero %. The Central Bank could then get on with managing the payment / settlement system with the power to supply liquidity as required for the smooth operation of trade and the protection of little companies, from big companies that take three months to pay their invoices.

    Some of you may be aware that in a fiat currency economy, taxes don't actually, physically pay for anything. In such an economy taxes are the fiscal "brake pedal", the opposite of the government's deficit spending fiscal "accelerator pedal".

    Mickey Mouse politicians have no understanding of the above and those that do, don't want the proletariat to get anywhere near understanding it. Hence we have a government that increased VAT as part of its idiot austerity plan, when the last thing the economy needed at that time, was an increase in a sales tax. A tax that would have the highest negative multiplier of GDP in the tool box. Taxation must be used to slow sectors, and sub-sectors, of the economy down, when an inflation creating bubble starts to appear in them.

    A Housing bubble needs a specific tax to be applied on a quarterly basis at least, to slow it down. A tax designed to grab that sector by the short and curlies. Yearly budget tax changes are far too slow to be effective fiscal control mechanisms. As L Randall Wray says, start taxing bads not goods.

    PS. The IFS Green Budget 2015 is worth a read particularly Chapter 6. The IFS brought in the Accountants to explain the government's WGA Accounts. The latter explain government finances in terms of IFRS accounting rules, the same as the likes of multinational companies are required to produce. As UK plc, the country is a total busted flush. It has massive negative working capital and its huge balance sheet liabilities are to be funded by future income. Try telling that to your Bank Manager. The Insolvency practitioners would have been called in decades back; nobody would buy it for scrap!

    Until that is, you understand that the government has a bottomless pit of its own money. It can bail-out itself any time and every time it wants; from now until the end of time. Acorn.

  5. Hi Simon
    Whilst you mentioned resistance to nominal wage cuts, given recent news of rising wages (1.7% ex bonuses) and projections for this to continue, might it not happen given the onset of deflation, which in turn may then lead to our predicted short-lived deflationary episode to go on longer than expected as wage rises are in fact curbed?

  6. Simon
    I do not have argument against logic or truthiness of your post only about complicated nature of the way it was explained. I would do it in simplified way.

    The assumption that monetary policy is capabele of only choking economy, that it can not help economy except by releasing the choke should be taken. With this assumption that monetary policy can not help economy everything becomes easy to understand stuff about ZLB:

    Another concept is two natures of inflation. Wage push and price pull inflation.
    Price pull inflation is bad, just simply bad, i do not think it needs explaining. But i will mention it, stagflation. Price pull inflation reduces purchasing power because prices go up while credit payments are fixed. It is reduction in real income.
    QE is only about price pull inflation so it was stoped when showed the signs of working. But crucial effect was achieved: banks are flushed with reserves which is the source that finances government spending.

    So we have a policy by FED that can only do squeezing of economic activity it can not help it. Neutral position is 0% interest rate. Anything above that can be considered choking economic activity.

    Since there is no wage push inflation only the signs of price pulled inflation which is bad for economy and oil price can do that there is no reason to start choking the economy.

  7. Inflation/deflation is a continuum. Nothing magical happens at zero inflation.
    Too low inflation is only marginally better than deflation.
    As inflation approaches zero, the ability to stimulate and economy with negative real interest rates goes to zero.
    Theoretically, inflation above 4% would allow monetary authorities to created a negative real interest rate of over 4%, much higher than the negative interest rates that can be created at inflation less than 2%. A 2% target gives monetary policy far less power than would a higher target.

    Wages and prices are sticky downward.
    The inflation rates needs to be high enough to allow most wages and prices to reset in the upward direction.
    Too low inflation prolongs the time needed to reset relative prices and wages.
    This creates prolonged periods of underproduction and underemployment.
    Inflation needs to be high enough to allow rapid resets of relative price after an economic shock.
    2% inflation is too low to accommodate more modest shocks making prolong economic downturns more likely.
    A higher inflation rate would accommodate much larger economic shocks.
    These factors suggest that a 2% inflation target is too low.
    Monetary authorities have settled on a 2% target based on a misunderstanding of how inflation and wage-price spirals operate. Why don't monetary authorities recognize that too low inflation gives them much less power to influence events?

    -jonny bakho

  8. "Quite simply, central bank credibility is destroyed because people believe they have lost the ability (rather than the will) to do their job, ..."

    Quite simply, you can't lose something you never had.

  9. We may want to keep in mind that the possibility of a rate rise by the US Fed can trigger some extra investment beforehand by some firms wanting to lock in a lower short-term rate. The Fed is evaluating extra lending at the moment.

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  11. A strange essay to write on the cusp of the ECB's finally starting it's own, proper (ie not the LTROs), QE. And the Japanese are ramping up their QE and beginning to kick out the faint hearts and hawks from the BoJ board and replace them with seriously committed (near) market monetarists.


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