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Monetary policy framework is the real issue, not inflation risk

Our knowledge of inflation dynamics remains limited

| Japan
Pedestrians on a street in Tokyo: the declining working-age population means a decline not only in labor supply but also in demand for goods and services.   © Reuters

Masaaki Shirakawa is a former governor of the Bank of Japan.

Assessments of inflation risk have now taken center stage in global financial markets after the surprise jump last week in the U.S. annual consumer price inflation rate for April to 4.2%. What is at issue is whether the rise in inflation is transitory.

As long as we take a traditional approach toward looking at the output gap, which is presumed to affect inflation, the official view of the U.S. Federal Reserve is understandable, because the two big events narrowing the output gap in my view are both essentially one-off in nature.

First, the successful vaccination rollout in the U.S. just means that the economy will go back to the pre-COVID era, which was characterized by low inflation. Second, expecting continued fiscal stimulus on the current scale is unrealistic. Eventually, a fiscal cliff, or waning of fiscal stimulus, is inevitable.

But this kind of reasoning does not resonate with nervous investors who are understandably concerned about a possible change in recent trends -- from a period of disinflation to inflation.

Looking back on the global trend since World War II, inflation started to increase from the mid-1960s and peaked around 1980. Then, the inflation rate gradually started falling and advanced economies enjoyed a long period of price stability. A period of low inflation -- or rather, a fear of deflation -- arrived after the 2008 global financial crisis, although Japan experienced this whole cycle 15 years ahead of other advanced economies.

What brought about this change? Some emphasize the role played by central banks. Surely, central banks are important, but just emphasizing this is naive or superficial: central banks do not exist in a vacuum. We have to look into the drivers affecting central bank monetary policy decisions -- the political, societal and intellectual environment. I feel uneasy when I hear central bankers say "we know how to cope with inflation, even if inflation risk should materialize." The issue is not a technicality.

Traders look on as a screen shows Federal Reserve Chairman Jerome Powell's news conference: reasoning does not resonate with nervous investors.   © Reuters

What on earth determines the trend inflation rate? In fact, inflation rates have largely stayed below the 2% target since the global financial crisis, despite the vaunted framework of inflation targeting and extremely aggressive monetary easing. This clearly shows how limited our knowledge of inflation dynamics is.

Let's start with the famous proposition often cited by economists that "inflation is always and everywhere a monetary phenomenon." What exactly is meant by this? If it means that inflation is generated by an increase in the central bank balance sheet, or central bank money, then that is clearly refuted by the recent experiences of many advanced economies.

I am not implying that central banks cannot be an anchor for price stability. Central banks can stave off deflation by acting as a lender of last resort to prevent the financial system from collapsing.

Almost all historical examples of deflation in modern times are confined to the 1930s and linked to the collapse of the financial system. Central banks can also eradicate rampant inflation by aggressive monetary tightening, as then-U.S. Fed Chairman Paul Volcker did from 1979 onward. But all this does not mean that central banks can set the inflation rate at the target level.

The intellectual framework most often used by economists has been the Phillips curve showing the relationship between the output gap and the inflation rate. In recent decades, however, the link between inflation and the output gap has been very much muted, probably because companies are losing pricing power on the back of globalization and technology change. I do not yet see convincing evidence that this situation is changing.

Given the current massive fiscal expansion, the theory that price levels are a "fiscal phenomenon" is particularly interesting. If people see the fiscal balance as unsustainable, the only way to restore fiscal balance is either through debt default or inflation.

Some argue that as far as advanced economies are concerned, an outright default is unthinkable because central banks can always purchase government bonds when needed. In such cases, high inflation is sure to result. Or, to be more precise, a jump in prices triggered by the flight to a safe-haven currency and resulting currency depreciation. This theory captures some important aspects of inflation dynamics, but it is silent about the short-run movement of the inflation rate.

Last but not least, there is a theory that emphasizes the role of demographics in explaining inflation dynamics. As Charles Goodhart and Manoj Pradhan argue in their recent, thought-provoking book The Great Demographic Reversal, favorable demographic changes, which are responsible for the disinflation trend since the 1990s, are now being reversed: declining working-age populations will push up wages and hence inflation.

I strongly agree with the importance of demographic changes, but I am not fully convinced by their argument. The working-age population is not only workers as a definition but also constitutes the core age cohort of spending. So, the declining working-age population also means a declining demand for goods and services.

On top of that, we have to think of the impact of a declining population, which is disinflationary, as distinct from rapid aging. It started in Japan in 2009 and will start in China within a few years.

Current concerns about inflation risk are quite legitimate. If the question is about an assessment of inflation risk, say, in the next three years, reflections on the above arguments have me distancing myself from the alarmists. But, given our limited knowledge of inflation dynamics, I am not wedded to this position. My point is just that focusing on inflation risk is dangerous when it comes to assessing the appropriateness of the current monetary policy settings.

As I have repeatedly argued here, it has not been inflation but financial imbalances that have caused considerable economic fluctuation in recent times. Prolonged monetary easing creates an odd equilibrium of low growth, low inflation and low interest rates. My sense is that we need to reconsider the prevailing intellectual framework of monetary policy.

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