Calling inflation “the dog that didn’t bark,” the International Monetary Fund on Tuesday said that the massive monetary easing undertaken by major central banks in recent years poses little risk of sparking a damaging run-up in prices down the road.
Since the 2008 economic crisis, and with the economy still weak, several of the world’s central banks have pumped trillions of dollars into the system through asset purchases and other unconventional tactics, a strategy that was reinforced last week when the Bank of Japan announced an aggressive new program.
The policy has been considered necessary to keep the economies of the developed world growing. But it has also raised concern that as growth strengthens, unemployment declines and the “slack” is taken out of the system, it will cause a rapid rise in inflation — potentially damaging in its own right.
With all that money in circulation, critics say, it will eventually be used to bid up prices for goods, services and workers.
But in new research released before the IMF’s spring meeting next week, the fund said it believes the nature of inflation has changed in recent decades, becoming less volatile and less likely to rise or fall in response to underlying changes in the economy. In class economic theory, prices and unemployment have an inverse relationship; when unemployment rises, prices tend to fall because people make less money and have less bargaining power to demand higher salaries. The reverse is expected when unemployment falls.
Although that general relationship remains, the connection has become less pronounced. In technical jargon, it means that the Phillips curve has become nearly flat, so that any rise or fall in the jobless rate has less of an effect on inflation.
Models of the U.S. economy based on earlier recessions, for example, would have predicted a dangerous period of deflation to have followed the sharp rise in unemployment that occurred in 2008 and 2009, after the financial crisis hit. But that didn’t happen; prices stayed on a modest upward trend.
From that and data on other developed countries, fund officials concluded that inflation has become more directly tied to the expectations and policies set by central banks. The argument relies a lot on market psychology. But the basic thrust is that because central banks have been able to maintain inflation in recent decades, people trust that banks will keep things stable and base their purchasing, investment and employment decisions on that expectation.
“In a curious incident, we find a dog that did not bark,” top fund staff wrote in a reference to a Sherlock Holmes story in which a non-barking dog provided a critical clue. “Inflation has been more stable than in the past both because it has become better anchored to stable long-term expectations and because the relationship between inflation and unemployment is much more muted. . . . There seems little risk of strong inflation pressure during the ongoing recovery.”
It is a convenient finding, for policy reasons. The fund has endorsed the extraordinary stimulus efforts by central banks, and it would be difficult to argue, midcourse, that the Federal Reserve, European Central Bank, Bank of England and Bank of Japan were collectively up a creek and needed to turn around.
The report also overlooks the fact that at least some of the flood of money released by the developed world has leaked overseas and may be building inflationary pressures or asset bubbles elsewhere. The IMF is studying that risk as part of a broader analysis of how the major central banks should plan their exit from the loose-money approach when the time comes.
And, of course, there is an important caveat: If the nature of inflation changed once, it could change again — particularly if central banks lose their touch, or their political freedom to respond.
The bad dog of inflation “has been muzzled,” the IMF said. “And, provided central banks remain free to respond appropriately, the dog is likely to remain so.”