Since the financial crisis, most developed economies have had ultra-loose monetary policy with low or even negative interest rates, however with little to none inflation. But it seems that we are now leaving the low-rate and low-inflation paradigm, as both are rising (very) fast by historical standards. As a result, the debate on the future of inflation and interest rates has turned the other way around: instead boosting low inflation with ultra-low interest rates to gauge the limit of inflation and how far central banks should go with their tightening cycle. To answer these questions, a more long-term instead of a short-term business cycle perspective is needed.
For decades, the guiding framework for economic policy was for central banks to implement “flexible inflation targeting” to achieve low and stable inflation (generally around 2%) by setting short-term interest rates (which are more reliable determinants of consumption and investments than the money supply, but which have a clear effect on employment and thus wages), while fiscal policy was to keep public debt low and redistribute income. But since the financial crisis of 2007-2008, advanced economies have experienced a rare occurrence: persistently low inflation and simultaneously low unemployment and ultra-low interest rates. This means that the Phillips curve, which explains the (short-term, inverse) relationship between unemployment and inflation has become flatter or is even “broken”. This greatly puzzled economists for years and had them searching for an answer as to where inflation had gone, as it meant that monetary policy had less effect on inflation rates and expectations and was thus becoming less and less effective. Research shows that shifting expectations of long-term monetary policy have been the most important factor in determining inflationary expectations.
However, since a few years, inflation has spiked again, the main reasons being the rise in energy and food prices that was accelerated by the Ukraine war, and an uptick in aggregate demand after the Covid-19 lockdowns and reopening economies (China’s in particular). Furthermore, economies are – aside from the “Covid-19 recession” of 2020 – well into their business cycles, with booming investments, employment and consumer spending driven by higher wages, all leading to more inflationary pressures. However, these reasons are mostly idiosyncratic (Covid-19 pandemic, Ukraine war) and short-term driven by the business cycle. Nonetheless, there are longer-term reasons that will fundamentally impact our inflation and interest rate outlook, and that could even lead to the view that inflation and thus interest rates will be lower in the foreseeable future.
First, we see that the demographic trend of ageing societies puts downward pressure on inflation and interest rates. Ageing societies in Asia and Europe create a shortage of workers and thus lower aggregate demand. Older generations also tend to save more than younger generations for their retirement, thus bringing more capital that depresses interest rates. On the other hand, ageing societies such as China could reduce the “global savings glut” that has depressed global interest rates in recent years. Furthermore, the elderly generally spend less than younger generations, as they have fewer major expenses such as education, housing and childcare (although healthcare spending rises significantly). Lastly, when people retire, supply to the labor market decreases, exacerbating labor shortages but also reducing wage growth and thus consumption spending.
On the supply-side, globalization has reduced (and synchronized) inflation rates as free trade has lowered production and transaction costs for producers, leading to lower consumer prices. Furthermore, outsourcing and increased shares of (semi-finished) imports in real GDP of advanced economies mean that excess demand can now more easily be distributed across global supply chains. Lastly, the integration of emerging markets into the global economy, again China in particular, has increased the supply of labor, hence puts downward pressure on wage growth across the world.
However, in an age of geopolitical competition and rising geopolitical risk, the trend of globalization could go in reverse, thus creating more inflationary pressures. Furthermore, the increasingly “politicized” debate about industrial policy and economic development, (see also the discussion of MMT) means that inflationary targets are becoming less important than other strategic goals (e.g. creating national value and production chains even though they consist of excess capacity from a global perspective, providing cheap credit to domestic strategic industries).
Digitalization is another factor that puts a more structural or secular (as opposed to cyclical or short-term) downward pressure on inflation. First, the internet facilitates a global market for local supply and demand, e.g. socks from Amazon or phone cases from China, thereby increasing competition and reducing the possibility of producers putting a mark-up on their prices. Furthermore, digital technologies, such as smartphones, allow consumers to leverage their own possessions in the gig economy. In this way, the marginal utility of capital goods can be increased and fewer capital goods need to be bought. Thus, sharing and access models decrease demand for specific capital goods such as cars or utensils. Furthermore, the data that is generated on these digital platforms can be used to further tailor supply to demand, hence further improve the “price discrimination” that generally lowers prices on the macro-level. More radically, the penetration and implementation of digital technologies will lead to new business models with deflationary pressure. Many digital business models have a “zero-marginal cost” proposition, in which digital products and services can be scaled at very little cost. Creating a digital education course or establishing a music or movie platform with a critical user base requires high up-front investment, but when this infrastructure is established or the equipment acquired, the service and products can be produced and distributed at little extra cost. When these digital or platform models expand, they can lower their prices (if they are kept from extracting monopoly rents).
Lastly, we see that fiscal orthodoxy is shifting, mostly due to rising populism and climate change, suggesting that governments are more willing to run fiscal deficits and continue spending in the economy without considering the longer-term inflationary impacts. One particular branch of monetary theory is “modern monetary theory” (MMT), which holds that debt-to-GDP ratios are irrelevant to countries that issue their own currency, as they can always print extra money, the only constraint on spending being inflation. As such, proponents of MMT argue that fiscal policy is the most important tool to achieve full employment (i.e. keeping up demand) and economic growth, and that the balance of spending in the public sector is mirrored by a balance in the private sector: a government surplus leads to private sector deficits and vice versa. Governments could then cause economic downturns as they lead to private sector deficits, which should be solved by deficits and government spending. Furthermore, taxation should be used to keep inflation in check, as it takes money out of the economy, thus keeping private parties from spending and pushing up prices. Additionally, inflation is not caused by excessive growth in which aggregate demand outstrips aggregate supply, but by large companies with market power that tighten supply and artificially drive up prices. As such, MMT holds that fiscal deficits are irrelevant as long as unemployment and inflation are low, and that the economy and inflation should be managed by fiscal instead of monetary policy.
Of more relevance with respect to our Zeitgeist and inflationary dynamics is the idea that governments need to fundamentally reform our economies to deal with future challenges (i.e. unemployment caused by automation, higher risk premiums and costs caused by climate change) and persistent problems (i.e. socio-economic inequality and environmental degradation) has made more active governments more fashionable. Indeed, the deep political transition that is needed is reflected in the active role of governments (e.g. some MMT proponents suggest that governments should provide “job guarantees”) and the use of fiscal policy to effectuate sustainable and socially responsible investments (e.g. the Green Deal). Furthermore, rising geopolitical rivalry and the return of the great power competition ask for governments that take a more pro-active stance in designing a future-proof industrial agenda. MMT, with its focus on fiscal instead of monetary policy, could become a tool for politicizing monetary policy instead of leaving it in the hands of “technocratic” central bankers, meaning that interest rates should be kept low to finance public spending (ageing societies could also raise public spending and deficit spending, most notably Japan and countries that fear “Japanification”).
Inflation is currently rising very rapidly in tandem with interest rates. As such, many are speaking of a new inflation and monetary paradigm, with new tools for assessing monetary policy and inflation outlooks. However, there are structural, longer-term reasons to think that this period might be relatively short-lived. Demographic, geopolitical, technological and political factors might all reduce inflationary pressures in economies, while also stimulating central banks to keep rates lower for longer. Tensions between shorter-term, business cycle dynamics and longer-term, structural trends will have to be reconciled in a future-proof inflation and interest rate outlook.
