Mysteries of Modern Inflation

The theory of inflation that I learned long ago suggested that inflation should creep up when an economy is running near full employment, but will come back down during a recession. However, for almost two decades now, the rate of core inflation (that is, inflation not counting the volatile movements in oil and food prices) has stayed low and hasn’t budged by very much. At one level, low and stable is clearly good news. But at another level, it raises a question of whether we really understand the causes of inflation. And if we don’t understand it, how much confidence can we have that it will remain low and stable.

This mysterious behavior of inflation has been widely recognized, including by Fed chair Janet Yellen. David Miles, Ugo Panizza, Ricardo Reis and Ángel Ubide have now tackled the question in “
And Yet It Moves: Inflation and the Great Recession,” published as Geneva Reports on the World Economy 19by the International Center for Monetary and Banking Studies(associated with Geneva’s Graduate Institute of International and Development Studies) and the Centre for Economic Policy Research.(October 2017). It’s available through  the VOX website (with free registration).

Near the start of the report, the authors offer a hypothetical question. If you were thinking about the path of inflation back in 2007 or so, and someone accurately described to you what was about to happen in the economy, what inflation rate would you have predicted? They write:

“[G]iven how volatile and often high inflation has been in the past, given that there was a deep recession and brief deflation episode in 2008-10, given that nominal interest rates were virtually constant (and the real interest rate was not), given that the monetary base increased five-fold, and given that central banks undertook unprecedented policies in a context of fiscal volatility, what would have been your guess about the stability and volatility of inflation from 2010 onwards?

“Simple versions of dominant economic theories, or superficial readings of economic history, would have all pointed to the conclusion that inflation should have at least been volatile, and possibly drifted up or down. Yet inflation was low and relatively stable. We did not observe deflation even in the presence of massive macroeconomic shocks and a sudden rise in unemployment, nor the much-feared inflation spiral that many expected after unprecedented easing in monetary policy. It is remarkable that the volatility of inflation remained so low, in spite of new policies and many shocks. …

“Overall, inflation has not diverged much from its 2% target and, if anything, has been below and struggled to return to 2%. One reaction to these facts is complacency: inflation is a solved problem that we do not need to worry about. This report rejects this view. We will suggest that the stability of inflation poses puzzles for our existing theories, suggesting that inflation control is far from a solved problem. Complacency, in our view, can quickly lead to inflation getting out of hand, in any direction, in the coming years. …