The mirage of inflation

Inflation seems close at hand but might be further away and harder to realise than we think

Inflation is something that seems just over the horizon but never quite appears. Every loosening of fiscal or monetary policy prompts a chorus of voices claiming that a surge in prices will be upon us but these fears recede into the distance as time passes. It may be the case that, like an optical illusion, the point at which inflation would kick in is moving away even as we inch towards it. The lack of inflation has been lauded but weak demand may see inflation transformed into something that we want to see happen.

Inflation looms large in economic theory. A jump in the level of prices would play havoc with how people go about their business, so economists have given prominence to policies aiming for stable prices. Clamping down on inflation is seen to be tricky as its impact is not just due to whether prices are rising or falling but also how workers and businesses expect the price level to change in the future. Predictions of higher prices would, for example, mean it would be more likely that companies would increase the amount they charge or that workers would push for higher wages.

In this way, inflation has the potential to be created and self-perpetuated out of the mere belief that prices might rise. To stop this from happening, central banks have been given licence to use tough measures (such as raising interest rates) to not only stamp out inflation but also to keep a lid on any fears that prices might rise up in the future. Just a bit of inflation of around two percent is seen as ideal and a healthy rate to which people can thus attach their expectations.

Things have pretty much gone to plan with inflation remaining subdued even as the economy has continued to grow and developing countries such as China have increased the demand for lots of raw materials. Central banks have been helped by favourable circumstances with the spread of the global economy lowering the price of many goods as well as reducing the possibility of shortages that might trigger price hikes. Other factors have also helped such as the decline in the bargaining power of workers and thus the potential for rising wages to feed through into higher prices.

The steady price level has opened up scope for policies that would have normally been seen as potentially inflationary in nature. The prime example being quantitative easing in the aftermath of the global financial crisis. This policy involved central banks purchasing financial assets as a means to boost the economy through higher prices for stocks and bonds as well as lower interest rates for financing. The large sums of fiscal spending to deal with the covid pandemic is another example of actions that increase the likelihood of inflation. But it is only in times of crises that policymakers tend to put their aversion to inflation to one side.

Considering the chaos that can potentially be caused by inflation, restricting price rises can be seen as prudent in the same way as an insurance policy – paying a small price now to stave off a bigger catastrophe in the future. Yet, like many policies, inflation targeting does involve trade-offs that are often ignored with the almost singular focus on the price level. One growing worry is that there might instead be too little inflation and deflation could potentially loom ahead as in Japan. That companies are unwilling or unable to raise prices suggests depressed spending and a weak underlying economy. There is also a possibility that low inflation is itself a cause behind the weak economic growth.

As a result, central banks have shifted their stance slightly to show more willingness to facilitate rising prices. Inflation of two percent is becoming more like a goal to achieve rather than a cap to limit price increases. One sign of this is interest rates now never get too far from zero even when the economy is growing. More could still be done to bolster demand especially since the threat of inflation is likely to be receding in the distance even as we try out more inflationary policies

Inflation may be getting away from us due to a further continuation of the economic trends that have already held back price increases. Globalization and stagnating wages have acted to keep prices down and will not change without dramatic shifts in how the economy is managed. Central banks are also not likely to ease up that much on inflation as otherwise they would risk having all of their hard work be undone. And recent history has shown us that any extra cash tends to flow into financial markets rather than boosting demand in the underlying economy.

Inflation might then end up like a mirage in the desert that retreats even as we advance upon it. Over time, how inflation appears to us will likely also undergo a shape change as emphasis continues to shift from avoiding overheating to bolstering demand. Rising prices may then become something to be fostered rather than avoided. As such, inflation could come to be seen as an oasis amid the mire of economic quicksand.