Central Banks Looking to Reduce Stimulus Face Quandary of Falling Inflation

Weak growth in prices questions traditional model of linking output and prices

By Paul Hannon and David Harrison

Mario Draghi, president of the European Central Bank, gave a speech last month that many investors viewed as signaling a readiness to remove some stimulus later this year or early next. Photo: PETI KOLLANYI/BLOOMBERG NEWS


Leading central banks plan to withdraw some of the stimulus measures they have put in place since the financial crisis. But their timing seems a little puzzling: Inflation, which is already below their targets, is falling world-wide.

The decline in inflation is a mystery since the global economy appears to be growing at a faster pace than during recent years, while unemployment rates continue to edge lower.

According to central bankers, inflation is generated by the gap between the demand for goods and services and the economy’s ability to supply them. When that output gap is wide, inflation is lower, and when it is narrow, prices grow more quickly. Low inflation is a symptom of a weak economy, something they want to avoid as much as high inflation, a sign of an overheated economy.

To boost inflation, central banks stimulate demand by lowering interest rates, encouraging households and businesses to borrow and spend. As the volume of goods and services that people want to buy nears the limit of the economy’s capacity to supply them, wages rise, as do prices, generating inflation.

But try as they might, central banks have been unable to reach their inflation targets over recent years, despite their success boosting growth and lowering jobless numbers. That has raised questions about the reliability of the traditional link between the output gap and prices.

“Central banks across the Western world are struggling to define that relationship,” said Bert Colijn, an economist at ING Bank.

Across the Group of 20 largest economies, which account for most of the world’s economic activity, annual inflation slumped in May to its lowest level since August 2016, according to the Organization for Economic Cooperation and Development.

Much of that decline was due to easing energy prices. But even excluding that volatile item, and similarly choppy food prices, “core” inflation is slowing in many places.

That isn’t a recent phenomenon. Core inflation in developed economies hasn’t changed much in the years since the financial crisis, never reaching the 2.5% rate it stood at in September 2008, when Lehman Brothers collapsed, or going below the 1.1% rate it hit in December 2010.

Central bankers are struggling to explain why inflation isn’t responding the way the textbooks say it should to an improving global economy and falling jobless rates. According to the OECD, the unemployment rate in developed economies fell to 5.9% in May from 6.3% a year earlier.

In the U.S., Federal Reserve Chairwoman Janet Yellen has shrugged off the past few months of low inflation numbers, saying they were caused by temporary domestic factors, such as cheaper new cellphone plans. But the global inflation slowdown calls that thesis into question.

Chicago Fed President Charles Evans suggested last month that poorly understood technological advances or aging populations could also be holding down inflation around the world.

“I sometimes wonder if there isn’t something more global, more technological that’s taking place that we don’t quite have our arms around very well,” he said.

Fed officials devoted part of their June 13-14 meeting to debating inflation’s surprising weakness. Some argued the link between the output gap and inflation had weakened over the past few years. Others worried letting the economy grow too fast would bring about a sudden burst of inflation that would be hard to control.

The picture is just as confusing in Europe.

In a June 27 speechthat was widely viewed by investors as signaling a readiness to remove some stimulus later this year or early next, European Central Bank President Mario Draghi said inflation has been weaker “than one would expect on the basis of output gap estimates and historical patterns.”

Mr. Draghi concluded that a narrowing output gap would eventually have its usual effect on prices. It would just take longer.

Other global factors may be at play. Because so many companies compete around the world, weaker economic growth and sluggish inflation in one country could keep a lid on prices in other countries, propagating low inflation across continents.

Another explanation could be lower inflation expectations around the world. After years of tepid price growth, workers may not push that hard for a raise and companies may not feel compelled to increase prices despite signs of improvement in the economy.

Whatever the cause, central bankers appear willing for now to look beyond the past few months of weak inflation numbers as they shift away from easy money policies. Faith in output gap theory is one driver. Some also are growing worried about other problems. For example, recent speeches from Fed officials and the minutes of the last meeting suggest a growing concern about financial stability as asset prices rise.

If consumer price trends don’t turn soon, however, central bank officials could find they have undermined the inflation mission they’ve established as their core objective.

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