By Liam Falconer
What happened to inflation?
In the finale of Tiffany Pollard’s (New York if you are in the know) hit spin-off show ‘New York Goes to Work’, Ms Pollard takes on the role of a professional boxer. Her opponent? The one and only Pumkin (sic). Enraged at her failure to appear, Ms Pollard exclaims “Where is this (woman)! Where is she!” Central bankers are asking the same question as they consider inflation’s silent retreat across the rich world.
Orthodox theory suggests that inflation is a consequence of tight labour markets and high output – a relationship represented by the Phillips Curve. It’s surge across the rich world in the 70s and 80s spurred a rethink of economic theory. However, aggressive inflation targeting since then has sent it trending downwards across the rich world to the point where no major economy has dealt with high inflation in decades. This was punctuated by the Global Financial Crisis of 2008, which contracted demand so sharply in many countries that deflation, negative inflation, became the bugbear of central banks. As economies recovered from the crisis and demand strengthened, unemployment shrank and output rose, but inflation was curiously missing. America, despite maintaining a tight labour market with unemployment at 3.5% (in the before times), was barely reaching the lower bound of the target. This article won’t even go into the time-sink that is Japan. Needless to say, this concept is not called Japanification for no reason.
So where has inflation disappeared to? In true economics fashion, there are countless theories. They can largely be categorised into two categories: theories involving the labour market and theories involving macrotrends. The labour market theories are micro founded, revolving around firm and worker behaviour. Some economists argue that there is an observed fall in worker bargaining power in the rich world. As a result, firms have been able to contain wage growth, lowering production costs and thus keeping inflation down. A closely related theory is based on the concept of Downward Nominal Wage Rigidity (DNWR). Pretty much all that needs to be know about this concept is that workers mostly only care about their nominal wage, not their real wage, and firms are inclined to not lower wages in downturns, just not rise them instead. Knowing that they cannot lower wages in downturns, firms are less inclined to raise wages in economic booms. Additionally, even as inflation erodes real earnings, worker’s focus on their nominal wage hinders it from increasing to keep up with a changing price level. As such, wages growth has been sluggish despite strong economic performance, keeping production costs low.
However, firm specific issues may not be all that is behind this phenomenon. A more recent idea is ‘the Amazon affect.’ That is, ecommerce, over which Amazon reigns supreme, has created substantial competitive pressure across retail. This has created downward pressure on prices as firms fight to maintain and gain market share.
Globalisation can be considered to have a similar role. In recent years, firms have been able to optimise supply chains across countries, enabling firms to take advantage of competitive advantages in markets outside that of the point of sale. This gives firms the opportunity to set lower price while maintaining profits. So, as is common in economics, there are many potential sources of inflation depression that could explain its recent absence.
The orthodox relationship between inflation and output has become noticeably unorthodox in recent years. The typical downward sloping Phillip’s Curve has become flatter as inflation has retreated across the rich world. While there are many theories that could explain this phenomenon, there is no clear reason nor a firm understanding of the consequences of this decoupling.
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