Dealing with disinflation

What’s at stake: Despite the continued presence of large amounts of spare capacity, core inflation has resisted falling further, and has instead stabilised across most of the world, including in the peripheral European economies that have been especially hit by the crisis. In the US, the FOMC just hinted at further QE by warning that inflation was below what “the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.”

Gavyn Davies argues that the Federal Reserve broke a taboo when it said quite baldly that inflation in the US is now below the level “consistent with its mandate”. In other words, it is too low. This is a very big statement for any central banker to make, since the greatest feather in their collective cap is that they successfully combated inflation after the 1970s debacle. Since that period, most central bankers have been careful to avoid any language which even hints that a rise in inflation is acceptable to them. I can certainly find no previous record of the FOMC saying that inflation is too low, so it was a jolt to see this stated so starkly in the Fed statement yesterday.

James Hamilton argues that the most natural interpretation of those words is that the Fed is aiming at a long-run inflation target that's higher than what we've been seeing lately. By its nature, that is a statement about what the Fed will be doing several years down the road, not a signal of something it's going to do in November. In other words, it sounds a lot like the Fed is trying to follow the Eggertson-Woodford policy prescription.

Twenty-Cent Paradigms notes that both the consumer price index and core PCE deflator are indeed consistent with the notion that the Fed is missing its target. The authors argue that the projection of board members' for inflation in the "longer run" can be taken as its unofficial target; and as of the last release in June, they were aiming for expecting 1.7%-2.0% (as measured by the deflator for personal consumption expenditures).  Moreover, the markets are sceptical that the Fed will hit it in the future, according to the Cleveland Fed: The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.54 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

MacroMania notes that inflation currently running at around 1% and pointing in the downward direction might, in and of itself, normally elicit only a modest concern. But combined with an economy presently weaker than expected, the concern is now heightened. And, in particular, the worry at present is the risk of a Japanese style deflation (a "deflation trap" in the minds of some, though I'm not even sure if such a thing exists).

Andre Meier documents the behaviour of inflation during 25 episodes of persistent large output gaps in 14 advanced economies over the last 40 years. He finds that such episodes normally have strong disinflationary effects without quite leading to outright deflation. He also finds that the subsequent closing of the output gap during a recovery doesn’t typically lead to an inflationary spike, raising doubts about the talks of ‘speed limits’ (in the sense of higher inflation when a negative output gap is closing fast. Speculating on the reasons why disinflationary momentum levels off before becoming deflation, Meier notes two possible reasons: First, if price-setters trust the central bank’s commitment, they have less reason to respond to short-term variation in marginal cost, and a weaker relationship between output gaps and inflation may ensue. Second, already-low inflation might well inhibit further disinflation because of downward nominal rigidities.

Alphaville notes that Meier’s conclusions are somewhat comforting. They suggest that there isn’t much prospect for an unwelcome inflationary spike spurred by looser monetary policy; but they also mean that outright deflation is also unlikely. And policymakers can get on with the task of closing that pesky output gap and reducing unemployment.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.