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John Greenwood | December 5, 2017

Why is inflation below target in so many advanced economies?

Since the global financial crisis, inflation in the advanced economies has persistently undershot their 2% targets despite unprecedented quantitative easing (QE), extraordinarily low interest rates, large fiscal deficits and near all-time low unemployment.

U.S. Federal Reserve (Fed) officials have explained that the weakness of inflation in 2017 is due to the reduction in the price of mobile-phone data charges. Similar one-off explanations such as commodity price weakness or technology-induced declines in prices have been also used in Japan and the eurozone to explain sub-target inflation. In this article, I will explore two mistaken theories of inflation and explain the true reasons behind inflation’s benign trend.

The misconception of fiscal deficits

The first misconception is the “fiscal theory of inflation” – the idea that large increases in the government’s fiscal deficit will inevitably lead to inflation. This theory is fundamentally erroneous except under one special set of circumstances. To show how wrong the theory is, consider the fiscal deficit under former U.S. President Ronald Reagan. It widened from 1.3% of gross domestic product (GDP) in 1980 to almost 6% by 1986 as he implemented tax cuts and increased defense expenditures. However, inflation declined from post-war highs of 14.8% in March 1980 to just 1.1% by December 1986. Why?

The answer is that Paul Volcker at the Fed adopted a tight monetary policy. From 1980 to 1986, tight monetary policy dominated over loose fiscal policy, causing inflation to fall. For broadly the same reasons, the inflation that was feared at the time of President Donald Trump’s election in November 2016 has not materialized.

The misconception of the Phillips Curve

The second misconception, known as the Phillips curve, is that inflation invariably accelerates as the labour market tightens and approaches a particular low level of unemployment.

The problem with the Phillips curve is that it is not so much a theory of inflation as an observed relation that sometimes works and sometimes does not. Over the past two decades, it has not worked in the U.S., Japan or Germany.

What really drives inflation?

As the economist Milton Friedman always said, “Inflation is always and everywhere a monetary phenomenon,” but the Phillips curve does not take into account the growth of money. Although advanced economies have had several years of QE, the commercial banks have not expanded their loans or deposits rapidly, partly due to the need to repair balance sheets, and partly due to stricter regulations that have slowed the growth of credit. This in turn has meant that deposit growth, and therefore M2 or M3 growth, have remained low. In short, low money growth has resulted in low inflation.

In essence, inflation is part of the business cycle, which is ultimately driven by monetary growth as shown in Figure 1. However, the Phillips curve only considers the relation between economic activity and inflation (the last two elements in the chart). So full employment can be a precursor of inflation, but if there has not been rapid money growth, there is no reason for higher inflation ahead.

Figure 1: Inflation is part of the business cycle

Source: Invesco: for illustrative purposes only

But if inflation has remained low, how is it that asset prices are so elevated? To answer this we need to distinguish between two different types of bubbles.

  • The first type is the result of rapid money and credit growth, usually associated with increased leverage. The damage from this kind of bubble bursting – either as a result of central bank tightening or due to a major financial incident like the Lehman Brothers bankruptcy in 2008 – can be very severe and long-lasting, as in 2008 and 2009.
  • The second type of bubble is a capital market response to low interest rates. When interest rates are low, prices for long-duration assets (such as long bonds, equities and real estate) tend to rise, and vice versa. Following eight years of slow money and credit growth, the advanced economies are currently in an extreme low interest rate, high asset price environment. This raises the next question: If central banks raise interest rates, will the bubble burst?

Will the equity bubble burst?

The answer to this question depends on where the advanced economies are in the business cycle shown in Figure 2. Currently I would say that the U.S. is the only major economy in Phase 3, where interest rates are being normalized, while the U.K., the eurozone and Japan are still in a very elongated Phase 2.

Figure 2: Prospects for the business cycle in the developed economies

Source: Invesco: for illustrative purposes only


So long as the business cycle continues to expand, as is likely for at least two to three years, corporate profits can continue to grow, providing an offset to the effect of rising interest rates. In short, more extended GDP and profit growth could offset some of the decline in the price-to-earnings ratio that should result from rising interest rates.

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M2 is a measure of the money supply that includes cash and checking deposits as well as savings deposits, money market securities, mutual funds and other time deposits.

M3 is the broadest measure of an economy’s money supply.

Price-to-earnings ratio measures a stock’s valuation by dividing its share price by its earnings per share.

Where John Greenwood has expressed opinions, they are based on current market conditions as of Nov. 30, 2017, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Unless otherwise specified, data was supplied by Mr. Greenwood. Past performance is not a guarantee of future returns.