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Economy

Unraveling the mystery of 'missing' inflation

Central banks confront curious case of stronger growth, stagnant prices

Economists are trying to get to the bottom of sluggish inflation in the U.S. and elsewhere.   © Reuters

TOKYO -- A burning question is keeping global economy watchers preoccupied: What explains the increasingly prevalent combination of stronger growth and low inflation? This mystery could have big implications for central banks eyeing the exit from monetary easing.

The U.S. Federal Reserve, for example, has decided to start gradually reducing its assets in October, prompted by solid employment. But while the Fed raised its growth forecast on Sept. 20, it lowered its price projections.

Established macroeconomic theory contends that a tightening labor market stemming from an economic recovery should produce inflationary pressure.

The Bank of Japan, too, is struggling to spur inflation above 0.5% and has repeatedly cut its price forecast, even though unemployment is down to a 20-year low. And the U.S. and Japan are hardly alone in grappling with stubbornly low prices.

Bank for International Settlements data shows that inflation rates for June were below 1% in 15 countries, and negative in Ireland, Saudi Arabia, Israel and Thailand. Even in fast-growing India, inflation stood at an eight-year low of 1.5%.

The International Monetary Fund expects emerging economies will see 4.6% average inflation this year, leaving the narrowest gap ever with the industrialized world.

New York University professor Nouriel Roubini, nicknamed "Dr. Doom" for his ominous predictions prior to the U.S. financial crisis, has a theory about "the mystery of the missing inflation" -- the title of a paper he issued on Sept. 13.

"One possible explanation for the mysterious combination of stronger growth and low inflation is that, in addition to stronger aggregate demand, industrialized economies have been experiencing positive supply shocks," Roubini argues in the paper.

He goes on to explain: "Globalization keeps cheap goods and services flowing from China and other emerging markets. Weaker unions and workers' reduced bargaining power have flattened out the Phillips curve, with low structural unemployment producing little wage inflation."

Deeper than oil

When talking about low inflation, it is natural to point to cheap oil. U.S. benchmark West Texas Intermediate crude futures have been hovering at around $50, down from about $100 a barrel in mid-2014. Saudi Arabia's inflation rate was around 4% through June 2016, but it fell sharply in January and remains in the negative.

Weak inflation might be considered temporary if it could be chalked up to low oil prices and stronger currencies of emerging economies. But Roubini and the vast majority of experts see deeper structural changes at work. 

Slow wage growth and limited household purchasing power appear to be getting in the way. In turn, BIS chief economist Claudio Borio pins the sluggish wages in industrialized countries on employers' access to cheaper labor and materials, thanks to globalization. Companies are increasingly able to hold down wages by shifting production overseas.

In addition, as the division of labor proceeds worldwide, manual jobs are being taken over by machines in Asia and elsewhere. Taiwan's Hon Hai Precision Industry, better known as Foxconn, is just one example of a company that is automating more of its production -- which also keeps prices in check. 

Plus, since the world economy is increasingly integrated, prices tend to move in similar fashion in both advanced and emerging markets.

Oversupply is an issue as well. As they have developed, China and other rising economies have rapidly boosted production capacity. But the growth rate of emerging economies -- which was around 7-8% before the global crisis -- is down to about 5%. This is making it harder to absorb all that output.

In some countries, insufficient demand is putting downward pressure on prices. The Organization for Economic Cooperation and Development says the output gap -- which it defines as the difference between actual and potential gross domestic product, as a percentage of potential GDP -- is minus 2.5% in Mexico and minus 4.5% in Turkey.

Yet another oft-cited source of deflationary pressure is the explosion of e-commerce.

Rick Rieder, global chief investment officer of fixed income at U.S. asset manager BlackRock, said the spread of smartphones has pushed down prices, since more consumers are finding discounts online rather than shopping in real stores.

Uneasy position

Low inflation has its benefits for emerging countries. They used to have little choice but to raise interest rates to restrain prices, even when their economies were sluggish. Now, they have more options, including rate cuts.

Sure enough, Brazil's central bank lowered interest rates at its eighth straight policy meeting on Sept. 6. Indonesia's central bank cut rates in August. Monetary policymakers in Russia and India are expected to cut rates further.

But after years of unprecedented monetary easing in Japan, the U.S. and Europe, low inflation creates a complex challenge.

The easing has pushed up prices of assets, such as stocks and property. Now, the Fed and the European Central Bank aim to start normalizing their policies to prevent bubbles. However, if they tighten too quickly while prices remain low, it could throw cold water on economic activity. 

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