Low Inflation: Why?

  • 12 Dec 2016
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Low Inflation: Why?

Interest rates around the world have been at record low levels for some years and there have been extraordinary increases in money supply by several of the world's major central banks through their bond purchase programs. Yet, contrary to general economic theory, inflation rates in most advanced economies remain very low.

The first graph, sourced from the Reserve Bank of Australia, shows the average rate of inflation for a range of countries over the past two years (the blue bars) as well as the average rate over the past 20 years (the black dots). In almost all economies, inflation has recently been noticeably below its long-term average. The second graph (also sourced from the RBA) shows a time series of inflation rates averaged across the major advanced economies. Again, the picture is clear. While headline inflation (the consumer price index) has picked up a little recently, the outcomes over recent years have been the lowest for many decades, except for a short period during the global financial crisis. Core inflation rates (inflation that excludes certain items with volatile price movements) have also been low, although not as much, as they do not capture the large fall in oil prices over recent years.

So why has this been happening given the highly accommodative monetary policies of the world’s central banks over the last few years? There seem several factors at work:

Intralink Lge Petal Graphic 3 Col:Line The first explanation is that the low inflation reflects the economic slack in the global economy. Excess capacity was generated in many economies during the boom preceding the global financial crisis. Given the subdued economic growth since then, excess capacity still exists in many parts of the global economy

Intralink Lge Petal Graphic 3 Col:Line The second factor is a self-reinforcing dynamic originating from the decline in inflation caused by the fall in commodity prices, including oil prices. With inflation rates so low, many workers have agreed to smaller wage increases than would have otherwise been the case. The low wage increases have in turn reinforced low inflation outcomes

Intralink Lge Petal Graphic 3 Col:Line The third factor is that there has been a shift in the perceived pricing power of many workers and businesses driven by the globalisation of markets and technology. Open markets and advances in technology mean that more businesses feel that if they put their prices up, they will not only lose market share to domestic competitors but to foreign competitors as well. One good example of this is in the retail sector, where the entry of foreign retailers has made a real difference in the pricing of groceries and clothing in Australia

Intralink Lge Petal Graphic 3 Col:Line Another contributing factor is that many workers and companies still carry scars from the financial crisis. The crisis generated a lot of uncertainty and increased the value placed on job security. This increased value put on job security has made many workers less inclined to push for large wage rises.

Looking ahead, the Reserve Bank of Australia expects that the various factors holding inflation down will continue for a while yet. But this does not mean that we have drifted into a world of permanently lower inflation in Australia. The drag on the Australian economy from the decline in mining investment is coming to an end. As this happens, the excess capacity, including in the labour market, is likely to decrease, and some pick-up in wages and prices could then be expected. In addition, commodity prices, after having declined over the preceding four years, have increased this year. If sustained, falls in commodity prices will no longer be having a significant effect on inflation. In terms of the downward pressure on prices and wages from increased competition, this is likely to continue for a while yet, but it is probable that this pressure will lessen at some point as domestic demand strengthens. Putting all this together, the RBA’s forecast is that inflation in Australia will gradually pick up over the next couple of years, although it is likely to be closer to 2 per cent than 3 per cent by the end of this period.