Weakness in US core inflation has been in the spotlight recently. Despite the economy operating above potential, with a tight labour market, inflation has stayed subdued and even trended down in the last few readings. One-off explanations like policy and methodological changes might partly account for this, but weak inflation is not only a US phenomenon. Most advanced economies, and some emerging countries, are witnessing lower inflation rates relative to similar points in previous cycles.
Econometric modelling, looking into the main drivers of inflation over time, reveals some interesting trends. Firstly, the impact of the output gap, a measure indicating where the economy is operating relative to its potential, on core inflation in the US, UK and euro area has fallen over the last few decades. In other words, inflation is not as sensitive to tighter labour markets or capacity constraints as it used to be.
Secondly, the impact of inflation expectations is also changing. In the US, the effect of inflation expectations has become less volatile and more consistent since the late 1990s, presumably as many central banks started shifting towards inflation targeting at the time, anchoring expectations. In contrast, euro area core inflation has become more sensitive to inflation expectations since the sovereign debt crisis, arguably as a result of ECB’s extreme policy measures, as well as Mario Draghi’s increased focus on inflation expectations since then.
Thirdly, while inflation is a persistent process, whereby past inflation is a decent predictor of current and future inflation, its degree of persistence has also declined, particularly in the US and euro area since the financial crisis.
Finally, external determinants of inflation such as import prices are also significant, but in line with more domestic-oriented drivers, have also become less important over the past few years. The currently low sensitivity of US inflation to import prices, for example, stands out relative to the mid-1990s and mid-2000s.
While no one factor fully explains the weakness in inflation we see today, together they probably do account for the lower sensitivity of inflation to traditional drivers and for the modestly disinflationary environment of the past few years.
So what does this mean? To begin with, given the lower sensitivity of inflation to its fundamental determinants, including output gaps, inflation expectations and inflation persistency, it is unlikely that we will see inflation accelerating or decelerating fast from current levels in the near-term. Low and stable is here for longer. It would also take a large shock – perhaps a sudden adjustment to labour supply or a sharp change in inflation expectations – for inflation to get out of its current range meaningfully. This is not entirely impossible in the current environment, perhaps Brexit or Trump could provide a catalyst for that.
For policymakers, this complicates an already enormous challenge. The economy has to run above potential, with more positive output gaps than currently for inflation to see a sustainable upshift, as well as inflation expectations potentially having to jump up (and stay there). In other words, to get inflation higher, central banks need to stay behind the curve for longer than their traditional models and policy rules suggest. This is not the strategy followed by the Fed at the moment, but perhaps the ECB has a chance, given the extreme level of accommodation still in place. Of course, falling behind the curve would raise the risks of financial instability even further, which central banks are acknowledging but struggling to address. This is a tough trade-off which will become sharper over the next few months.
Anna Stupnytska is global economist at Fidelity International