One of the age-old economic theories is that of the Phillips Curve named after William Phillips. The concept behind the Phillips curve is that in the “medium term” (an imprecise length of time between one and five years) there is a direct relationship between price growth and the level of unemployment in the economy. Therefore, as unemployment falls below a key threshold, known as the “non-accelerating inflation level,” inflation begins to rise.
Today, however, particularly in advanced economies, this relationship appears to have broken down. Despite robust growth, consumer price inflation is showing little sign of upward pressure and in many cases, remains below central bank targets. Today, policy makers find themselves in a quandary.
Core inflation in the US surprised on the downside recently, increasing by just 1.6% annualised for the month of June. Janet Yellen had previously stated that unique and unforeseen factors, such as the declining oil prices, had dampened core inflation growth. However, with oil prices comparatively stable and relatively low inflation throughout the rest of the developed world, this explanation may not be entirely correct.
On Wednesday, Janet Yellen indicated that the Fed expects to begin winding down its balance sheet of bonds and asset backed securities that it built up over the last few years to stimulate the economy.
The process is loosely known as “policy normalisation”. What was more striking about the announcement is that it gave no mention of when interest rates would likely rise. Investors had been expecting a hike later in the year. That signalled to some that the Fed wants more time to assess the inflation data and that they are taking its persistent weakness seriously.
This data also comes on the back of near natural rates of unemployment in the US at just 4.3%, yet inflation appears to remain unresponsive. Inflation would normally rise during times of a tight labour market as more confident workers push employers for higher wages. More surprising still is that the weakness in inflationary pressure is becoming more broad-based in the US which is the opposite of the intuition behind the Phillips curve.
Lastly, another concern is that “Trumpflation” – as President Trump’s fiscal stimulus proposal to overhaul US taxes and infrastructure has been dubbed – is looking less likely given the political climate and the ongoing failure to pass meaningful healthcare reform legislation.
Japan has wrestled with stagnant and falling prices for many years now. Until recently, it looked as if it would overcome this tendency and achieve low, stable inflation. Moreover, Japan can boast its longest economic expansion in over ten years. Despite this, core CPI stood at 0.4% in May and did not show any immediate signs of increasing. Increasing price competition from fast-growing e-commerce companies has forced large traditional retailers to cut prices in response.
Given the ease and convenience of comparison and research via online shopping, traditional retailers must bend over backwards to maintain footfall in their stores. Therefore, although e-commerce sales are small relative to the industry, they have strong pricing power. The Bank of Japan does not expect to reach its 2% inflation target until early 2019. Why?
Low Inflation as the Norm
One possible idea floated is that in the developed world, people have been living under comparatively low levels of inflation since 2012. Therefore, their expectations of inflation have been altered in that they do not have the same instinct or inclination to ask for pay rises. Consumers can also become used to stagnant or even falling prices. This low, stable inflation has a reinforcing effect over time as, despite anaemic wage growth, consumers are not considerably worse off in real terms.
Moreover, there is intense price competition from online vendors such as Amazon, who exploit their lower cost business model to keep a lid on prices, from Walmart in the US to Aeon in Japan. Moreover, their heavy reliance on groundbreaking technology makes them more nimble and efficient than many other “big box” retailers.
It is true that when inflation is low in one country, its exports are price competitive and it can help to keep other countries inflations low too. This could be the case of low inflation in several major countries propagating globally.
This is certainly a possibility given the low and stable world oil price. Brent crude is hovering around $50 per barrel, and that feeds into the cost of producing countless numbers of goods from food to clothing.
A More Flexible Labour Market
Technology is also playing a huge role – both for workers and businesses. Innovations such as Uber have awoken the previously sleepy taxi market and put downward pressure on prices. Similarly, technology has placed a growing emphasis on transferable skills rather than vocational skills that are constantly at risk of extinction.
With transferable skills, workers are more adaptable and better able to change jobs to suit the economy’s needs. This could explain why inflation has not picked up despite the perception of strong employment. Structural changes have occurred which reduce the “natural rate” of unemployment.
Whatever the reason is, it is likely to concentrate the minds of policy makers for some time to come.