The Taiwan Banker

The formation of inflation expectations, the transmission mechanism of money creation on prices, and the triggers of inflation are undergoing structural changes, but our understanding of these changes is still quite limited. What is the impact of a weaker trade-off between output and inflation on monetary policy? Since the inflation rate has become less sensitive to changes in the unemployment rate, when the government adopts expansionary monetary or fiscal policies to boost aggregate demand and increase output to reduce the unemployment rate, it does not have to pay the price of inflation. This seems like good news; after all, what's wrong with long-term low inflation? However, past data (especially for Japan and the Eurozone) show that when an economy experiences low inflation for a long time, it usually reflects economic weakness, and there is a very high probability it will fall into a deflationary trap: inflation below expectations causes people to revise their expectations downwards, which in turn drives actual inflation down further. A dynamic cycle between low inflation and inflation expectations is not easy to reverse. Moreover, falling inflation is expected to directly lead to lower nominal interest rates, which reduces the space for the central bank to further cut rates to support the economic recovery, weakening the ability of monetary policy to stabilize the economy. The impact of “missing inflation” on monetary policy Since 2018, Fed Chairman Jerome Powell has repeatedly mentioned at Jackson Hole Economic Symposia that the natural rate of interest (or equilibrium real interest rate) in the US has shown a long-term downward trend. The natural rate is an important indicator of monetary policy, and is mainly driven by fundamental factors such as population structure and productivity growth. It must be observed through estimation. According to the estimates of John Williams, President of the Federal Reserve Bank of New York (Laubach and Williams, 2003; Holston, Laubach and Williams, 2017), the long-term decline in natural rates is a global phenomenon. The Fed estimates that the natural rate in US has fallen below 1% since 2010, which is 2 percentage points lower than in the years before the financial crisis. Since the natural interest rate is an important indicator of monetary policy, when it drops sharply while maintaining low inflation for a long time, it means that the central bank's policy interest rate will be close to its effective lower bound (ELB). When the policy rate drops close to the ELB, employment and output no longer respond to monetary policy, which reduces the space for the central bank to further cut rates to support economic recovery, and increases the downside risks for employment and inflation. A kinked Phillips curve explains the mystery A recent study (Linde and Trabandt, 2019) shows that the Phillips curve is indeed flat, but only locally. If non-linearity is allowed in the estimation, the slope of the curve at the low end is greater than at high unemployment (Figure 1). This kinked Phillips curve can explain the aforementioned mysteries of both “disappearing inflation” and “disappearing deflation.” During the great recession, due to the flattening of the Phillips curve, a large increase in the unemployment rate did not lead to severe deflation; and during the recovery period after the recession, despite the quantitative easing (QE), before the economic activity was fully restored relative to its potential output, price and wage inflation remained low. In addition, this formulation also implies that when the unemployment rate drops to a certain critical value, the Phillips curve may become steep, triggering a sharp increase in inflation. The long-term structural factors inhibiting inflation have weakened The next question we have to ask is whether the main forces that have stabilized or curbed inflation in the past will continue to exist. What long-term structural factors have been loosened? What circumstances may trigger a substantial increase in inflation? (1) De-globalization and supply chain reorganization After the financial crisis, global supply chains began turning to insourcing or regionalization. Since 2018, the trade war and protectionism have accelerated these trends. The outbreak of COVID-19 further exposed the fragility of global chains. Bottlenecks in the key links of multinational chains, including food, medical equipment, medicines, and key components, may force entire industries or departments to shut down. In order to ensure that the supply chain is not disrupted in the future, strategic intermediate goods and products will shift from offshore outsourcing to local or regional production. Supply chain reorganization is however bound to increase production costs. If the flattening of the Phillips curve mainly came from globalization, intensified de-globalization and supply chain reorganization due to protectionism and the pandemic may mean that the past power of more efficient commodity and labor markets to suppress inflation through globalization will gradually weaken. (2) Population ageing and labor shortage As mentioned earlier, the increased participation rate of the elderly labor force due to aging helped suppress increases in wages. However, as the baby boomers retire, the dependent population increases, and the labor force population declines in relative terms. When the overall labor force declines more than the elderly labor participation rate increases, labor shortages will prompt wages to rise; moreover, as the dependent population increases, demand for overall consumption grows faster than productivity, which will also bring inflationary pressure. Goodhart and Pradhan (2020) showed in their book The Great Demographic Reversal that the demographic structure of emerging economies such as China is aging, and the effect of labor reduction will eventually exceed the inhibitory effect of rising elderly labor force participation rates on wages. Coupled with the trend of deglobalization, this may reverse the output growth and price stability brought about by the rise of emerging economies such as China and India over the past 30 years, leading to global wage and inflation increases. (3) Monetization of government debt After the financial crisis, major central banks implemented large-scale asset purchase plans. Since a large portion of this money was used to purchase government bonds, this triggered a debate on the monetization of government debt. The central bank directly provides credit to the government through lending, which is regarded as monetary financing and is prohibited by the laws of many countries. The purchase of government bonds through the secondary market gets around this issue, but there seems to be no clear division between the two. As the pandemic worsened, countries launched large-scale relief programs and fiscal incentives. With the implementation of extremely low interest rates and unlimited QE, many countries’ government debt ratios broke historical records, highlighting worries about the monetization of government debt. To a certain extent, QE is quite similar to monetary easing, confirming the ascent of Modern Monetary Theory (MMT). At the same time, despite the implementation of QE after the global financial crisis, financial institutions deleveraged on a large scale, failing to effectively stimulate credit expansion, causing a credit trap, and therefore not driving inflation. However, following the pandemic, QE has been accompanied by a substantial increase in total money supply and credit to enterprises and households, allowing the effect of extremely loose money to be transferred to prices. (4) Inflation and inflation expectations are gradually heating up In addition to the recent gradual rise in global inflation, it’s worth noting that inflation expectations have also risen significantly. After a sharp decline following the outbreak of the pandemic in early 2020, the breakeven inflation rate, which is the rate expected by financial markets derived from the spread between 10-year nominal US treasury bonds and inflation-protected bonds (TIPS), eventually broke 2%. The Survey of Consumer Expectations released by the New York Fed shows that the median consumer estimate of inflation in the next year rose from 3% in January 2021 to 4.8% in July. The University of Michigan's consumer expectations survey also found that one-year inflation rate expectations rose sharply from 3.0% in January 2021 to 4.2% in June. Therefore, both the financial markets and survey data shows that inflation expectations have gradually increased. In the past, the Fed emphasized that the anchor of long-term inflation expectations is quite stable. However, inflation expectations are self-fulfilling. If the long-term inflation anchor starts to loosen, it could increase inflation expectations and cause actual inflation to rise through various channels. (5) Central banks are losing credibility against inflation Through these recent monetary policy framework changes, these central banks have systematically increased their tolerance of inflation, which is an important structural change. If monetary policy played an important role in anchoring inflation expectations in the past, the problem now is that central banks’ credibility against inflation is weakening. Losing the long-term inflation expectations anchor could bring fundamental changes, reversing the trends of low and stable prices over the past few decades. Short and long-term factors From the previous discussion, we know that even if those short-term factors did not continue to exert pressure on inflation, there are signs of qualitative change in the above-mentioned main forces that maintained the stability of global inflation and inflation expectations in the past. If the Phillips curve is not completely flat, an increase in inflation may be triggered under certain circumstances. At the same time, if the anchor of inflation expectations is fundamentally loosened, it would shift the Phillips curve outward and drive inflation up sharply. The formation of inflation expectations, the transmission mechanism of monetary policy on prices, and the triggers of inflation are undergoing structural changes, but our understanding of these changes is still quite limited. Inflation trends in major developed countries and the effects of their monetary policies will spill over to other countries, especially small open emerging market economies, through channels such as commodity and labor trade, international financial transactions, and capital inflows and outflows. Therefore, central banks around the world must face the short- and long-term structural factors that affect inflation and expectations. Soaring stock prices and housing prices The above discussion perhaps still fails to provide a clear direction, but it is precisely because of this huge uncertainty that inflation is worthy of our caution, continuous observation and in-depth study. As The Economist magazine commented on the global pandemic on December 12, 2020: “If we’ve learned anything from 2020, it’s that problems most people in the world no longer worry about may come back with sudden and terrifying force.” Finally, in addition to the possibility of inflation, there is also the issue of global capital floods causing stock and real estate prices to soar. Ultra-low long-term interest rates and extremely loose monetary policy have increased the market's willingness to take risks. Sharp inflation and contraction of asset prices are no less harmful than hyperinflation and deflation. Asset price inflation not only distorts resource allocation, encourages zombie companies, drags down long-term productivity growth and increases the uneven distribution of income and wealth, but may also cause asset prices to collapse, triggering a financial crisis, which would deepen and prolong the depression. in particular, large influxes of hot money and outflows upon reversal are particularly harmful to emerging economies. However, as global asset prices and public and private debt ratios continue to set new historical highs, major central banks will face a dilemma between stabilizing prices or stabilizing finance. This all occurs in the foreground of a potentially substantial increase in inflation.