April 22, 2014

Alan Levenson Alan Levenson, T. Rowe Price Chief Economist

Economic theory teaches that inflation is, in the long run, a monetary phenomenon. Indeed, persistently high inflation in the 1970s—too much money chasing too few goods—was brought to heel by a sharp tightening of monetary policy. Higher interest rates raised the cost of current consumption, reducing the demand for goods and services into alignment with the economy's sustainable supply potential.

By contrast, in developed markets in recent years, the reverse has not readily been the case: Undesirably low inflation, and the attendant risk of slipping into outright deflation, has proven more difficult to dislodge despite record-low interest rates. (See chart below.)

Advanced Economy Inflation Broadly Below 2% Policy Target

This is because—particularly in the aftermath of the credit bubble and financial crisis—channels linking monetary policies to lending, borrowing, and spending decisions have been impaired. Even with low interest rates, high debt levels and low asset values have suppressed private sector spending. Governments have tightened budgets after postcrisis spending surges, working at cross-purpose to monetary policies, and tighter lending conditions have reduced the supply of credit.

Moreover, in the wake of deep recessions, wide margins of economic slack—including high unemployment and low rates of industrial utilization—undermine inflation pressures. Thus, across a range of advanced economies with accumulated debt overhangs, inflation remains below target levels despite extraordinary monetary stimulus.

At the same time, there is considerable variation in inflation outlooks and deflation risks among the major developed economies, depending on nations' monetary policies and their progress repairing links by which monetary policies influence financial conditions and spending decisions.

In the United States, inflation in the Personal Consumption Expenditures Price Index excluding food and energy is fractionally lower (1.1%) than it was five years ago (1.2%) when the Federal Reserve embarked on its first round of large-scale asset purchases. (All data are as of March 31, 2014.)

Yet underlying deflation risks are much diminished. There is considerably less slack in the economy: The unemployment rate has fallen to 6.7% from a cycle high of 10.0%, and industrial capacity utilization has risen to 78.4% (2.4 percentage points below the previous cycle peak).

In addition, private sector deleveraging is substantially complete. Financial corporations have slashed debt from 119% of gross domestic product (GDP) at the end of 2008 to 82%. Households have pared mortgage debt to an 11-year low of 74% of disposable income from a peak of 100%. Debt service—periodic principal and interest payments on all forms of debt—is down to a historic low of 9.9% of disposable income.

Finally, U.S. household wealth effects have reversed course compared with five years ago, when sharp drops in house and financial asset prices induced a shift toward saving, which exacerbated the shortfall in demand. Double-digit growth in house and share prices over the last two years has lifted household net worth by $15.9 trillion to a six-year high of 639% of disposable income. This has increased the scope for spending in excess of income growth, which would underpin a cyclical inflation lift.

Deflation risks are greater in the euro area, where current inflation is lower than in the United States and is still falling, with several countries' rates below 0.5%. (See chart below.) A weak economy increases the downside risks.

Perilously Low Inflation in Parts of the Euro Area

To be sure, euro-area real GDP is expected to grow by roughly 1% this year after two years of contraction. But this pace will not quickly alleviate slack in the economy, which is ample: The unemployment rate for the 18-country area stands at 12.0% and is still climbing in Italy and the Netherlands.

Euro-area growth prospects are hampered by the very slow pace at which the overhang of private sector debt is being addressed. The combined debt of households and corporations rose from 281% of GDP in mid-2004 to a peak of 368% in mid-2009, and it has since receded only to 355%. Finally, the recent evolution of household balance sheets has been mixed. As in the United States, net financial assets have regained pre-crisis peaks—yet euro-area house prices remain depressed.

The adverse consequences of wage and price deflation can be substantial. Consumers may welcome lower prices, but falling incomes increase debt burdens—reducing funds available for current spending and thereby worsening the spending shortfall. Particularly when the central bank has cut policy rates to near zero, as is the case in the euro area, falling inflation raises real interest rates, also encouraging the deferral of current spending.

Finally, to the extent that these pressures are greatest in the most indebted economies, with the highest rates of unemployment and weak banking systems, a mounting deflationary tide would aggravate the financial fragmentation that has plagued the euro area since its crisis broke in 2010.

In the months ahead, European Central Bank (ECB) actions will be critical to staunching these risks. The bank has recently extended its interest rate guidance, anchoring expectations that short-term interest rates will remain low into 2016. A renewal of long-term liquidity loans is likely in due course, well before those offered at the end of 2011 come due later this year.

The lingering challenge will be to develop a consensus for asset purchases and to design a means appropriate for a single central bank serving 18 distinct issuers of sovereign debt.

The Bank of Japan (BoJ) has shown that decisive action can disrupt a deflationary trend. At the urging of newly elected Prime Minister Shinzo Abe, the BoJ embarked roughly a year ago on an aggressive program of asset purchases with the aim of ending chronic deflation. Its goal: to achieve some time in 2015 a 2% inflation rate, in line with the objectives of other developed economic central banks, including the Fed and the ECB. And the early results are encouraging: Inflation in the Japanese Consumer Price Index excluding food and energy has risen to +0.7% from -0.9% a year ago.