Does Low Inflation Pose a Risk to Economic Growth and Central Banks Reputation?
The low inflation in advanced economies (AEs) in the years following the global financial crisis (GFC) of 2007–2009 provoked several questions of both a theoretical and a practical nature. First, fears of deflation were continuously present in both policy analyses and recommendations. Even if, fortunately, these fears never materialised, it was difficult to deny the presence of various deflationary pressures. Therefore, the second issue concerns the nature of these pressures – that is, the factors that determined these pressures and whether they had a temporary/one-off or permanent character. In this context, the third question concerns the role of monetary policy in countering deflationary pressures – in particular, the unconventional measures widely adopted by major central banks. This led to the fourth question on an exit strategy – monetary policy normalisation after deflationary pressures seemed to fade and both economic growth and employment recovered in 2015–2018. Finally, there is the question of the impact of the GFC, the post--crisis unconventional monetary policy measures, persistent low inflation and the new mandates and policy roles assumed by central banks on their reputation and independence.
Following the debate on monetary policy challenges in the post-GFC period and communication of monetary authorities (Draghi, 2019) one can get an impression that too low inflation is a key challenge faced by central banks. It may have negative consequences for their reputation (because they underperform the targeted/declared inflation level), in addition to negative effects on economic activity.
While we agree that deflationary pressures, which largely resulted from financial disintermediation (partly caused by the GFC itself and partly by new financial regulations and the unconventional tools of monetary policy), posed a major challenge to central banks in the previous decade, we do not believe that they continue to be a problem today nor will they be a problem in the near future, unless the world economy suffers a new financial crisis comparable to that of 2007–2009. Looking at the potential shocks that may hit the world economy, such as trade conflicts or security threats, we expect inflationary shocks rather than deflationary ones, so a continuous focus on deflation risk means fighting the previous war. Furthermore, in our opinion, the very low but positive inflation – if it is going to continue – has neither negative consequences for an economy nor can it damage central banks’ credibility.
The purpose of this paper is to justify our opinion analytically and to offer policy recommendations in respect of the future policies of central banks. Given the limited size of this paper, we will concentrate on inflation trends and monetary policy instruments, only marginally touching on other policies, such as fiscal and structural ones, or the more general debate on growth potential in a contemporary global economy and the major national economies.
The structure of the paper follows the above list of questions. In Section 2, we will look at recent inflation trends and try to answer the fundamental question of whether inflation is too low – in particular, whether the major advanced economies continue to face a deflationary threat. In Section 3, we will analyse the major deflationary factors of the last decade along with their sources. We will also try to predict whether they will continue in the near future. In Section 4, we will discuss the nature of the reputation risks faced by central banks that may lead to undermining their institutional independence and what kind of policy corrections can mitigate such risks. Section 5 contains conclusions.
In our analysis, we will use the data sources of the International Monetary Fund (IMF), Eurostat, the European Commission, the European Central Bank (ECB), the Frankfurt Stock Exchange and Robert Shiller’s database on US stock and home prices.
Author: Prof. Marek Dabrowski
This paper is based on a briefing paper prepared for the Committee on Economic and Monetary Affairs of the European Parliament (EC ON).