After fiercely fighting inflation over decades, central banks are now trying to revive it by all means, be it quantitative easing, negative interest rates or currency depreciation. This poses an intriguing question apt for fans of conspiracy theories: do central bankers know something that the rest of us don’t?
The policy twist followed the financial crisis, when the Fed decided to embark on “quantitative easing” in order to avoid that a slump in aggregated demand could be worsened by an excessively tight monetary policy, as had previously happened during the Great Depression. However, the downward trend in inflation had not started then. In fact, Ben Bernanke himself had advanced the “Great Moderation” paradigm, whereby advances in central bank “technology” were relegating macroeconomic volatility – including inflation – to the history books.
Bernanke’s technocratic complacency omitted the fact that inflation had already been long decreasing due to other factors not influenced by central bank “magic”. Two politico-economic forces can be identified beneath the deflationary tide. The first is globalization, which combined with technological advances and improved managerial skills, has enabled companies to make huge strides in optimizing production and distribution costs. To mention a few, the use of outsourcing, off-shoring, robotics, inventory management and on-line marketing is surely behind the sharp decrease in prices of goods and services. Moreover, during this process, workers’ bargaining power evaporated, severing the traditional link between corporate profits, wage pressure and inflation. The second force was the formation of currency blocs around the US dollar and the newly created Euro, which meant bringing many inflation-prone countries under monetary discipline.
The deflationary trend would be more acute if, as economists have long suspected, real inflation rates are significantly lower than those reflected in official statistics. Broadly speaking, the reasons for the mismeasurement are the late accounting for newly introduced products that exhibit a rapid decline in price (see graph), as well the failure to capture quality improvements. Moreover, the Internet revolution has brought a whole range of new services that are either offered for free (Google, Facebook, YouTube, etc.) or below economic cost (Airbnb, Uber, etc.), and which are barely included in the official price statistics.
This debate is not new and reached its zenith in the late 90’s when the proponents of the “New Economy” paradigm commanded by Alan Greenspan argued that large productivity gains – particularly in the growing service sector – were being understated by an inaccurate measurement of inflation. In fact, the so-called “Boskin commission”, appointed by the US Senate in 1995 to study possible bias in the computation of the CPI, found that the CPI was overstating inflation by more than +1%. At the time, with the CPI hovering north of 3%, this was not a reason for concern. However at current levels, it would mean that we are currently experiencing deflation.
If this is true, the economy would not be in bad shape when thinking in terms of productivity and real economic growth. The danger however is that once a deflationary trend is in motion, corporate profits and rents sooner or later start to decline, which in turn deflate asset prices and increase the value of liabilities. This threatens the very foundation of the financial system and would thus explain the mystery behind central bank’s unorthodox behavior.
Fernando de Frutos, MWM Chief Investment Officer
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