Dealing with disinflation

Posted by Cardiff Garcia on Sep 23 20:13. 2 comments | Share

Plenty of pixels have been used here on the inflationista vs deflationista debate, but fewer about a third category that doesn’t get as much attention: the disinflationista.

Okay, no such thing. But we’ve previously discussed the work of the IMF’s André Meier, in which he looks at 25 previous episodes of persistent large output gaps (long, deep recessions and sluggish recoveries) to find that they normally have strong disinflationary effects without quite leading to outright deflation.

He also found that the subsequent closing of the output gap during a recovery doesn’t typically lead to an inflationary spike.

This has obvious implications for what’s happening now — particularly in the US, as the FOMC just hinted at further QE by warning that inflation was “below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.”

Meier has now summarized and updated his paper, at VoxEU, to include his thoughts on the current crisis. He first speculates on the reasons why disinflationary momentum levels off before becoming deflation (emphasis ours):

– First, the literature has emphasised the enhanced credibility of central banks in preserving price stability in recent years.

Such credibility would be apparent not only in low average rates of inflation, but also in a strong anchoring of inflation expectations. If price-setters trust the central bank’s commitment, they have less reason to respond to short-term variation in marginal cost, and a weaker relationship between output gaps and inflation may ensue. …

– Second, already-low inflation might well inhibit further disinflation because of downward nominal rigidities, which appear to be common in wage-setting (see Akerlof et al. 1996 and Benigno and Ricci 2010).

This explanation would also account for the scarcity of outright deflation in the sample. Given the resistance to nominal cuts, it may take truly exceptional circumstances (perhaps epitomised by Japan’s experience during the last two decades) to create negative wage and price dynamics.

For the record, it is precisely that credibility, mentioned in the first explanation, that Bernanke has cited as his reason for not setting a higher inflation target.

Meier’s second explanation provokes a logical follow-up question: will we find ourselves in such a “truly exceptional circumstance” during the current feeble recovery? We’re not there just yet — at least not in the US, where inflation is at historically low levels but has remained steady in the last few months.

And here is Meier with the global picture (our emphasis):

With these aspects in mind, it is worthwhile to consider actual inflation trends during recent quarters. Using the same definition for the historical sample, we identify 15 ongoing output-gap episodes in advanced economies. This time round the decline in output is unusually large, although labour markets have held up better in relative terms. In fact, widespread labour hoarding appears to have driven up average unit labour costs in many countries, even as nominal wage growth has eased. Another striking feature is the rollercoaster ride of oil (and other commodity) prices, which first fell precipitously but have since recovered some of the lost ground. While these swings had a considerable impact on headline inflation, a general downward trend is nonetheless apparent (see Figure 3).

Figure 3. CPI inflation during the global crisis relative to historical output gap episodes (%)

And once food and energy prices are stripped out from the CPI, the pace of disinflation actually looks very similar to the historical precedent. In other words, median inflation has eased by about 20% of the initial inflation rate p.a. so far – about the same rate as in earlier output-gap episodes.

Of course, Meier is careful to note that just because the current recession is following the historical pattern thus far doesn’t mean other, unprecedented factors can’t make it deviate from the past.

So as always, don’t get too comfortable

Related links:
Inflation dynamics during episodes of persistent large output gaps – VoxEU
All aboard the QE2 – double or quits – FT Alphaville
Disinflation right on schedule – FT Alphaville