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Investment Bank

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Keeping inflation under control has been the goal of major central banks ever since it hit generational highs during the oil crises of the 1970s. During the 1980s, inflation trended down as tackling price rises became a priority for policymakers around the world. But in recent years, inflation has gone missing. 

Inflation has fallen below official targets (i.e. typically 2%) in many countries, or even descended into deflation (i.e. persistently falling prices). Moreover, markets and central banks have consistently failed to predict this trend, repeatedly forecasting higher price increases only to be surprised when they continue to fall.

Today central banks find themselves fighting to bring back inflation rather than suppress it. To achieve their goal, they have ventured into the uncharted territory of purchasing assets and/or introducing negative interest rates. But are these the right measures?

What’s been driving inflation down? 

Better monetary policy, liberalisation of markets, technology, and globalisation, including the global integration of China, explain much of the disinflationary trend of the 1980s and 1990s, when lower, stable inflation was celebrated as an achievement. Since the global financial crisis of 2008-09, however, these trends have become deflationary, as economies face overcapacity, high debt burdens, excessive savings and low productivity. 

FIG 1. The known factors leading to missingflation

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Source: OECD, Barclays Research

Monetary policy shift
Introduction of inflation targeting in 1980s & 1990s

Domestic liberalisation
Deregulation and privatisation limits indexation of wages to inflation

Technological progress
Global value chains and automation drive up efficiency

Globalisation
Global integration, in particular that of China, increases labour competition and reduces wage bargaining power

Post financial crisis
High debt burdens, overcapacities (incl. in China), excessive savings and slow productivity drive inflation down

Labour markets hold the key

Unemployment in the US, Japan, Germany and the UK has already fallen back to the relatively low levels seen prior to the global financial crisis of 2008-09. The big question now is: will recovering labour markets finally generate the higher wage growth that could help foster rising prices?

FIG 2. Unemployment and hourly earnings

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Source: OECD, Barclays Research

'12 - '16 Unemployment rate
Good progress has been made to return unemployment rates to levels seen before the financial crisis

'12 - '16 Hourly earnings
Although wage growth stabilised as unemployment fell, it is still significantly below the rates at which wages grew pre-financial crisis

As the world has become more integrated, so has inflation: as a result, the process of inflation must be treated as a more global phenomenon… 

Prices

Goods produced in different countries have become closer substitutes. It is the GLOBAL demand for products that now drives their price

Wages

Labour and capital markets have become closely integrated. Domestic wages are more dependent on labour supply globally

Correlation of cross-country wage growth has risen from 23% in 1996-2000 to 58% in 2010-20141. Meanwhile in advanced economies, the percentage of GDP accounted for by wages has fallen from 64% in 1980 to 57% in 20152.

Source:  BIS (2015), Barclays Research
2 Source: OECD, UN Barclays Research; based on Germany, France, Italy, Japan, Australia, Canada, UK and US

 

Are inflation predictions wrong because we’re using outdated models?

The inadequacy of assessing inflation on the basis of domestic factors alone is evidenced in the poor performance of the inflation forecasting models of the past 15 years: based on domestic output gaps and cost pressures, such models have systematically over-predicted CPI inflation. This suggests that global structural factors, such as those shown in FIG 1 above, rather than domestic cyclical factors, have become a driving force behind inflation. 

68%

In an econometric analysis of global factors in 16 OECD countries’ inflation developments, the key drivers were the same for 68% of the variation in cross-country inflation – suggesting that global shocks play a far greater role in determining domestic inflation that is often assumed.

Source: BIS (2015), Barclays Research

What’s so bad about deflation?

Falling prices, on the face of it, may seem like good news for consumers and anyone looking to buy goods and services. But, in fact, persistent declines across the cost of goods and labour can create a vicious cycle of falling demand (as cash is hoarded in the prospect of further price falls), lower investment, rising unemployment and increased debt defaults, which further reduce spending.

The vicious deflationary cycle

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What does missingflation mean for us all?

Low interest rates - To offset continued falls in inflation, central banks are imposing lower nominal interest rates. Low interest rates can have both positive and negative implications for households, corporations and governments: 

Governments, corporations and also households can borrow at lower costs...

 

...but those saving for old age also earn lower returns on their capital... 

….while other assets prices such as equity and real estate receive a short term boost because savers are more likely to spend. 

And negative rates – In some cases, central banks are imposing negative rates. In other words, they are charging depositors for lending to them. So far, these negative rates aren’t being passed on to general consumers, but large depositors are facing them and even smaller retail depositors are seeing account fees rise.  

And if that fails….fundamental policy change
There is a limit to how low negative rates can go before they begin to create significant problems – to banks’ profitability and their ability to lend to the wider economy; to depositors as their savings are eroded; and to pensions and life insurers seeking to meet their commitments to policyholders and retirees.

If inflation continues to fall, central banks may be forced to abandon inflation targets and seek a completely new way to manage monetary policy. But the process of evolving towards something new can be painful and could lead to disruption of the global financial system.

But unconventional monetary policy can only go so far

Global aggressive easing policies such as the buying of commercial bank and private sector assets, to encourage lending and increase money supply, could have significant unintended consequences, and raise concerns about financial stability. Ultimately, fiscal policy and productivity-enhancing structural reforms of the product and labour markets will have to play their part in helping to revive inflation.

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Read the full report

Authorised clients of Barclays Investment Bank can log in to continue reading The Fight to Bring Back Inflation and subscribe to #missingflation on Barclays Live.

For further information about Barclays Research offering, please contact barclayslive@barclays.com.

 

About the analysts

 

Christian Keller is a Managing Director and Head of Economics Research at Barclays, leading the coverage of both developed and emerging markets. Christian is based in London and joined Barclays in 2007 from the International Monetary Fund (IMF) where he had been the Resident Representative in Turkey since 2005. Prior to that, he was based at the IMF headquarters in Washington D.C., working on IMF programs with emerging market economies in Europe, Latin America and Asia.

Marvin Barth is a Managing Director and Head of FX Strategy, leading the firm’s global FX research product from London. Prior to joining Barclays in January 2014, Marvin spent five years as a strategist and as a portfolio manager in the US for Covariance Capital Management and Tennenbaum Capital Partners, spanning multiple liquid and illiquid assets. Previously, he spent three years at Citigroup in London and was responsible for the firm’s fundamental economic views on the G10 FX markets.

Marvin also has extensive policymaking experience as the former Chief Economist for International Affairs at the US Treasury Department, as well as an international economist at the Federal Reserve Board and at the Bank of International Settlements. 

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