For decades, one of the predominant concerns for governments around the world was how to keep price rises in check. This campaign led to the establishment of independent central banks mandated to hit strict inflation targets in order to maintain price stability and ensure confidence in currencies.
That fear, however, is increasingly giving way to worries about the spectre of disinflation, as global inflation continues to decline.
In a speech in March this year, Bank of England Governor Mark Carney announced that inflation had fallen globally, with the rate of price rises “below target in 16 of 18 inflation-targeting major economies … Eleven of those countries have inflation rates below 1%.”
Why is inflation collapsing?
In part, the decline in global inflation since the 1970s reflects the success of central banks in moderating price rises.
By allowing independent central banks to set interest rates independently of governments, policy-makers hoped to keep inflation around a stable level consistent with full employment. In large part, they have been successful in achieving that aim, although they have not been able to fully mitigate the impact of the economic cycle on inflation and employment.
Moreover, this period has also seen profound labour-market reforms. Widespread unionization of the private sector has largely dissipated, and with it collective wage bargaining that many blamed for helping to fuel wage/price spirals. They have been replaced with minimum-wage legislation and an increasingly casualized labour force that is much more flexible to changes in the wider economy.
These developments have meant that the days of wage/price spirals appear to be past, but some economists also blame this increase in labour-flexibility for an unwanted cocktail of stagnant wage growth and underinvestment.
These not only weigh on inflation but also pose a risk to future economic growth. In other words, where labour costs become so flexible that companies can decide to hire low-cost workers rather than invest in new technology or machinery, productivity can be held back, and so can the potential for GDP growth.
Influence of emerging markets
Another key factor in this dynamic has been the rise of emerging markets, particularly China. Since the advent of the General Agreement on Tariffs and Trade (GATT) and then China’s accession to the World Trade Organization (WTO), the global labour market has seen a huge influx of new supply, helping to keep down wage growth but also substantially reduce the cost of goods (and in some cases services, too).
That downwards price pressure has helped to offset the impact of credit-fuelled demand in Western economies in the 1990s and early 2000s, allowing central banks to meet their inflation targets despite high domestic demand and tight labour markets that would usually lead to an overshoot.
That problem has now been reversed, however. As a post by M&G’s Bond Vigilantes explains:
The deflationary forces leaking out of China stem from the Chinese authorities’ response to the 2008 crisis, where they embarked on huge infrastructure and investment spending. As previously argued on this blog, the investment bubble has become frighteningly inefficient. The consequence of China’s overinvestment was to create excess supply and overcapacity, which has proven disinflationary, but now China has to also contend with stagnating domestic demand.
If the disinflation exported by China in the 1990s and early 2000s was benign, as some have argued, this latest variety prompted by overcapacity and sluggish re-balancing towards domestic demand is unlikely to be described in such glowing terms.
One area its effects have been most keenly felt is in commodities markets, with the sharp drop in emerging market demand exacerbating the competition over market share between OPEC and U.S. shale oil.
A world of low inflation is not what the global economy needs right now. For one thing, although debt-to-GDP levels have fallen in some of the countries hardest-hit by the financial crisis, overall global debt has risen much faster than growth since 2008. While the pace of credit growth has slowed in developed markets, it has more than been made up for by debt build-ups in emerging economies.
Low inflation and sluggish global growth will make eroding that debt pile all the more challenging, and is also likely to force central banks to keep interest rates closer to the zero lower bound than they are comfortable with (limiting their ability to deal with possible future shocks).
Whether another debt shock can be avoided will depend on coordinated efforts to maintain modest post-crisis recoveries in the developed world and avert a debt hard landing in emerging economies.
Author: Tomas Hirst is editorial director and co-founder of Pieria magazine and was previously commissioning editor, digital content at the World Economic Forum.
Image: People take photos with the skyline of the financial district of Singapore in the background April 14, 2014. REUTERS/Edgar Su