American Consequences - June 2019

Debates about inflation in advanced economies have changed remarkably over the past decades. Setting aside (mis)measurement issues, concerns about debilitatingly high inflation and the excessive power of bond markets are long gone, and the worry now is that excessively low inflation may hamper growth.

Moreover, while persistently subdued – and, on nearly $11 trillion of global bonds, negative – interest rates may be causing resource misallocations and undercutting long-term financial security for households, elevated asset prices have heightened the risk of future financial instability. Also, investors have become highly (and happily) dependent on central banks, when they should be prudently more fearful of them. In search of new ways to produce higher inflation, the major central banks have tended to favor a cyclical mindset, making frequent references to insufficient aggregate demand.

But what if that is the wrong lens through which to view current conditions, and we are actually in the middle of a multi-stage process in which strong disinflationary supply-side forces eventually give way to the return of higher inflation? In that case, monetary policymakers and market participants would need to consider quite a different opportunity-risk paradigm than the one currently being pursued. To be sure, after coming close to central banks’ 2% target in 2018, core inflation rates in Europe and the United States have since been declining. The conventional measure of market expectations for inflation – the break-even rate on five-year U.S. Treasuries – remains stubbornly below target, even though the six-month moving average pace of job creation is almost 50% above the historical level needed to absorb new labor-market entrants so deep in the economic cycle. Though the U.S. unemployment rate (3.6%) is at its lowest level in around five decades, the labor-force participation rate (62.8%) also remains relatively low.

Owing to the persistence of low inflation, monetary policies have remained ultra-loose for an unusually long time, raising concerns that

the U.S. or Europe may succumb to “Japanification.”

By Mohamed A. El-Erian

American Consequences

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