The major central banks all are committed to avoiding deflation with their ultra-easy monetary policies. They prefer the phrase “unconventional monetary policies” to describe what they are doing. They all are aiming to boost their consumer price inflation rates to 2.0%.
They are confounded that they haven’t succeeded in doing so despite several years now of zero interest rates (and more recently negative interest rates) and quantitative easing — entailing purchases of government bonds and mortgage-backed securities in the US, government bonds and more recently corporate bonds in the Eurozone, and almost everything but the kitchen sink in Japan.
Actually, collectively the G-7 central banks aren’t that far off their 2% target. They are closer to it based on their average core inflation rate, excluding food and energy, than based on the headline rate. Their aggregate CPI rose 0.6% y/y through February. The core increased 1.7%. The comparable measures for the OECD, comprising 34 advanced economies, rose 1.0% and 1.9%.
The problem is that the US weighs heavily in these numbers, with the headline CPI up 0.9% y/y through March and the core index up 2.2%. Furthermore, the Fed prefers to target the PCE deflator, which has been slower-rising than the CPI owing to a much smaller weight from fast-rising rents. It was up 1.0% and 1.7% during February on headline and core bases.
Meanwhile, the Eurozone’s CPI was unchanged in March, and up just 1.0% on a core basis. Japan’s CPI is available through February and rose just 0.3% overall and 0.8% excluding food, alcoholic beverages, and energy.
Actually, given the extraordinary amount of monetary stimulus, it is remarkable that inflation isn’t well above 2%. If someone had predicted back at the start of 2008 that the combined balance sheets of the Fed, ECB, BOJ, and PBOC, measured in dollars, would be up 157% through March of this year, the chorus of critics would have said that’s not possible since the resulting hyperinflation would force the central banks to cease and desist such folly.
After all, everyone knows that “inflation is always and everywhere a monetary phenomenon,” as Milton Friedman once taught. He was a monetarist macroeconomist.
Keynes macroeconomists believe that monetary policy can be used to achieve full employment and that the trade-off will be higher inflation, as determined by the Phillips Curve.
It’s certainly time for the central bankers to reconsider whether Friedman’s truism is true. Empirically, it has been dead wrong. The problem is that the central banks are run mostly by macroeconomists, who are policy wonks. They simply fail to appreciate that there are powerful, deflationary microeconomic forces at work that are making even their unconventional policy tools ineffective.
Consider the following:
(1) War & Peace.
A chart of the US CPI since 1800 shows very clearly that inflationary periods have been associated with wartime conditions during the War of 1812, the Civil War, World War I, and World War II through the Cold War. The restoration of peace is associated with outright deflation, i.e., falling prices after each one of these wars with only one exception. There has been no deflation since the end of the Cold War, though the CPI inflation rate has declined from 4.7% y/y during November 1989, when the Berlin Wall was toppled, to near zero today.
During wartime, government takes command of the economy since all resources must be mobilized to win the war. Global trade is disrupted since there can be no trade among combatants, and it can be hard to trade with allies. In other words, wars are trade barriers. During peacetime, globalization occurs. There is more free trade even among former adversaries, and markets become freer from government controls and also more competitive.
The end of the Cold War in 1989 was the end of biggest trade barrier of all time. It led to China joining the World Trade Organization during December 2001. So far, it has been different this time because there has been no deflation. That’s because so far the central banks have succeeded in averting it with ultra-easy monetary policy, but not in achieving their 2% inflation target.
Macroeconomists don’t spend much time thinking about markets, especially competitive ones. These markets tend to be very deflationary because having fewer barriers to entry during peacetime means that established, profitable producers are constantly under attack from startups hoping to take some, if not all, of their profits by providing better goods and services at lower prices.
As a result of the IT revolution, entrepreneurs are able to disrupt business models in every industry with innovations that provide consumers with the best goods and services at the lowest prices. Steve Jobs was the entrepreneurial capitalist who started the personal-computing revolution by inventing operating systems that could run PCs, laptops, smartphones, and iPads. All these devices have become increasingly affordable, compact, portable, and powerful thanks to the Cloud and other innovations.
In the GDP accounts, the price deflator for IT capital equipment spending has declined 79% since 1977, when Apple introduced the Apple II, a color computer with expansion slots and floppy drive support. Capital spending, in current dollars, on IT equipment, software, and R&D now accounts for over 40% of the total of such spending, up from just 23% during 1977.
Technological innovations have had the most deflationary impact on consumer durable goods in the CPI measures of the seven developed countries that show this component along with the nondurables and services sub-indexes of the CPI. In the US, the consumer durables CPI peaked at a record high during September 1996 and is down 16% since then. Over that same period, nondurables and services are up 47% and 69%, respectively.
Here’s the rundown on consumer durables CPIs among the seven countries reporting these data since the start of 2001: Japan (-43.0%), Switzerland (-26.2), Taiwan (-22.5), Sweden (-21.8), UK (-15.1), US (-13.6), and Eurozone (-0.6). All of them registered increases in their overall CPIs over this period led by gains in both nondurables and services, with the only exception being nondurables in Switzerland.
There’s not much central banks can do about technology-driven deflation in consumer durables industries, which have embraced automation and robotics. They’ve boosted their productivity, while global competition has reduced their profit margins. Why would central banks want to stop this major source of deflation, which is clearly benefiting consumers?
People are living longer and more comfortably in their old age. The problem is that government deficits have swelled to finance entitlement spending rather than public investments in infrastructure. There also has been a plunge in fertility rates around the world, which might be partly attributable to the perception that raising children is expensive and not a good investment if the government will support us in our old age, obviating the need for adult children to do that.
These demographic trends are likely to be deflationary, since older people tend to consume less than younger people with children. This might explain the strong secular correlation between the inflation rate in the U.S. and the Age Wave, which is the percent of the labor force that is 16 to 34 years old. The Age Wave has dropped from a record 51.2% during January 1981 to only 35.6% currently. Over that same period, the CPI inflation rate has plunged from over 10% to under 2%.
Dr. Ed Yardeni
is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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