Even though more than 10 years have passed since inflation was hot, it has been a hotly debated topic since the Lehman crisis. Immediately after global credit markets went into cardiac arrest, central banks pushed their policy rates down towards zero and gave financial institutions unlimited access to longer-term central bank funding.
These actions were immensely important in stabilizing the financial system and received widespread support.
When it became clear that the negative fallout in the real economy was larger and more persistent than anticipated, central banks were forced further into unconventional territory. The main instrument of choice was the large-scale purchase of sovereign and/or private sector bonds. This policy of quantitative easing was heavily criticized by some pundits and applauded by others. Critics in the US predicted that QE would lead to a sharp acceleration in inflation and dollar debasement. This was back in 2009 and since then, core inflation has mainly hovered well below 2% while the dollar has appreciated by more than 20%.
Because of severe political constraints Europe was pretty late in the QE game and was only able to implement it when deflation risks became glaringly apparent in 2015.
The critics at the ECB mostly argued that QE could be a threat to financial stability because it would keep interest rates “artificially low” while taking away the incentive for peripheral governments to reform. In our view, the key trigger for low core EMU yields was the double-dip recession of 2011-13, which itself was the result of misguided concerted fiscal tightening and procrastination on the part of EMU politicians in solving the acute phase of the crisis. Furthermore, QE acted as a much-needed liquidity backstop for peripheral sovereigns. This gave a much-needed boost to growth and, as such, allowed them to make reforms which otherwise would have been very difficult to implement.
Now that unemployment rates in developed markets are closing in on, or in some cases even falling below, their pre-2008 lows, the question is to what extent inflation will become hot again. To answer this question, economists use the Phillips curve, which assumes that inflation is driven by inflation expectations, the output gap and shocks like the oil price or exchange rate.
In addition to this, inflation expectations in Europe may have slipped below the target, something that has clearly been the case in Japan to a far greater extent. The significance of this should not be underestimated. If inflation expectations are anchored to the target, then an economy at full employment will tend to deliver on-target inflation. If expectations have slipped downward, only an overheated economy will deliver price stability.
Uncertainties surrounding the equilibrium unemployment rate, the sensitivity of inflation to domestic slack and inflation expectations thus translate into uncertainty about the inflation outlook. Still, DM inflation outcomes over the past five years suggest that the combination of these factors worked in the direction of keeping inflation more subdued than generally expected on the basis of pre-crisis correlations. In other words, the Phillips curve has been pretty flat. This has been an important factor keeping central banks on the dovish side of the spectrum. An unexpected inflation acceleration could thus have a big effect on markets going forward. Even though this is not our base case, the risk of this happening is biggest in the US. The US unemployment rate has already fallen below 4% and is likely to fall further to levels not seen since the early 1950s due to the fiscal sugar high. At some point this could push the economy on a steep part of the Phillips curve, though this is far from certain.
The risk that Europe will hit a steep part of its Phillips curve in the next 12 months or so is a lot lower because the unemployment rate is still 1pp above its 2007 low while structural reforms undertaken since then have probably pushed the EMU NAIRU lower than it was 10 years ago. To the extent that inflation expectations have slipped, this will act as an additional damper. For Japan, the stickiness of inflation expectations at levels well below 2% clearly means that the economy can overheat for quite some time before inflation accelerates materially. Finally, the EM picture is very diverse. The countries with large imbalances such as Turkey and Argentina have seen big currency depreciations which are pushing inflation expectations higher. However, many other countries have seen more limited upward inflation pressure due to oil price increases and exchange rate depreciation. These forces must be balanced against the fact that many of these economies still have a moderate degree of slack.