By Blu Putnam, CME Group
At a Glance
- Core inflation in the United States has been stuck in a narrow range for 25 years
- With changing demographics and more price transparency, the Federal Reserve has less impact on the inflation rate than in past eras
Inflation is subdued and there is nothing the Federal Reserve (Fed) can do about it. Inflation pressures are low in part because of demographics and price transparency with enhanced competition.
Indeed, core inflation in the United States has been stuck in a very narrow range for the last 25 years, rising only as high as 2.55 percent and falling to a low of 0.9 percent.
During this period equities rose and fell twice, interest rates and unemployment have cycled up and then down, and through it all the inflation rate has remained essentially between 1 percent and 3 percent regardless of monetary, fiscal policy, or economic growth trends. To better understand why central bankers can no longer have much impact on the inflation rate, we need to delve a little deeper into the underlying constraints on inflationary pressures.
U.S. Demographics Have Changed
Baby boomers are retiring and spending less, a lot less than they did when they were working. The appetite for spending shrinks in retirement. Their retirement income is constrained. Many were dependent on interest income from savings, and super-low interest rates have destroyed that source of income.
New generations are entering the work force, but not in as large of numbers as in the past. The prime working age population in the U.S., ages 25 through 54, has virtually stopped growing. Moreover, the younger generations are saddled with huge student debt loads – meaning they may marry later, have kids later, buy a house later, and so cannot make up the slack from the retiring boomers.
Price Transparency with Enhanced Competition
The Internet has empowered consumers in the form of price transparency and the ease of competitive shopping. Companies must focus on cost-cutting to maintain profit margins rather than raise prices because raising prices can mean a loss of business. And the focus on cost has meant very sluggish wage gains.
The Fed has no antidote to either demographics or price transparency with enhanced competition. Both of these factors are major structural changes in the economic environment.
Economists that assume demographic patterns never change will find that their policy models created when the population was younger and growing more rapidly will no longer work. Similarly, in the pre-Internet days, companies were the dominant player in control of the information flow on product characteristics, and companies had some degree of pricing power, especially for established brands.
In the highly transparent and competitive Internet Age, consumers have gained control over the product information flow and are able to comparison shop like never before, resulting in a loss of pricing power for corporations. If the policy model fails to take this structural shift into account, it is going to over-estimate future inflation and get it all wrong.
Of course, policy is often tied to economic theories whose assumptions no longer make any sense – such as those with demographics and price transparency with enhanced competition. Indeed, the Fed has been frustrated with the path of economic growth and inflation since 2010, when it was expecting a much faster economic recovery from the Great Recession along with growing inflation pressures. So, the Fed has tried several ways to create inflation.
The Fed tried near-zero short-term interest rates and failed. Low rates help sustain equity markets by lowering corporate borrowing costs to assist companies maintain profit margins in the era of price transparency with enhanced competition. But, low rates reduce spending because they hurt middle-class and low-income savers, including those baby boomers hoping their savings would earn some interest to support their retirement plans.
The Fed also tried massive purchases of Treasury debt securities and government-guaranteed mortgages. This policy, known as Quantitative Easing (QE), failed. QE worked to support equity rallies by reducing market volatility, lowering bond yields, and reducing the hurdle rate for equities.
That is, QE did create asset price inflation. But, QE had virtually no impact on consumer spending, because the asset price inflation mostly helped the very wealthy, who spend only a very small proportion of any stock market gains, if any. Hence, QE’s asset price inflation did not translate into any consumer price inflation.
In Europe and Japan, their central banks went a step further and tried negative interest rates. That is, the European Central Bank (ECB) and the Bank of Japan (BoJ) forced banks that were required to hold deposits at the central bank to pay the central bank for that privilege. The idea was to encourage the banking system to lend more money, which would lead to more spending from businesses and consumers. In reality, the negative rates were a tax on the banking system. For the most part, banks found it impossible to pass on this tax to their consumer or commercial depositors. Like most taxes, at some point, the tax constrained economic growth.
The ECB and BoJ also took QE to new levels, buying so many government bonds that they have driven German and Japanese bond yields into negative territory. This sends an extremely pessimistic signal to market participants about future economic prospects, that they must pay the government interest to own sovereign debt.
The result of both negative rates and pushing so many bonds into negative yields has coupled with the impact of the trade war to push Germany toward recession. Again, the economic evidence is very clear that negative rates and negative yielding bonds are a tax on the economic system that has slowed growth and in no way has been the “accommodative” policy that was advertised.
Where Do We Go From Here?
Where do we go from here now that we know that central bankers have much more limited powers than they once thought they had? We anticipate more and more political pressure for tax cuts and increased government spending. If central bankers cannot create more economic growth and inflation, let’s try fiscal policy.
Some countries, such as Germany, run government budget surpluses, so they have plenty of room to increase spending and run an expansionary fiscal policy. The U.S., with its trillion dollar a year budget deficits, has no such room, which does not mean it will not expand its budget deficits. The bipartisan deal that lifted the debt ceiling also allowed for more spending and even larger budget deficits. We shall see if bigger budget deficits will be inflationary, but like monetary policy, fiscal policy does not address the fundamental causes of low inflation – aging and slow- growing populations, coupled with price transparency and enhanced competition.