N°30 MARCH 2016
ECONOTE
Societe Generale
Economic and sectoral studies department
A WORLD WITHOUT INFLATION

The huge money creation of Quantitative Easing (QE) has led to
concern about runaway inflation in developed countries. So far, however,
those fears have not materialized. Quite the opposite, as in most of these
countries the inflation rate remains below or well below the official targets of
the main central banks (typically 2% or just below). Global inflation has been
on a downward trend since the early 1980s.

This paper argues that the advent of anti-inflation-oriented central
banks in the late 1970s combined with structural shifts in the global
economy, such as globalization, technological innovations and weakening
trade union influence, have been key factors behind falling trend inflation in
the developed world. Since 2008, this strong disinflationary trend has been
compounded by a powerful negative demand shock.

Will inflation remain low? We expect core inflation (excluding volatile
food and energy prices) to remain low across much of the developed world
in the foreseeable future. This is partly because of structural trends, which
have likely durably reduced the long-term inflation rate. But this is also due
to enduring weak aggregate demand and wages. Moreover, there is a real
danger that current low inflation will actually become self-perpetuating.

This is because, in a world of very low inflation, the probability
increases that three crucial constraints will bind: 1) the difficulty for central
banks to reduce their policy rates substantially below zero, 2) sticky nominal
wages, and 3) Fisherian debt deflation mechanisms. As these constraints
become binding, economies are left grappling with higher unemployment
and underutilization of production capacity which, in turn, keep exerting
downward pressures on prices.
Marie-Hélène DUPRAT
+33 1 42 14 16 04
Mariehelene.duprat@socgen.com
ECONOTE | No. 30 – MARCH 2016
Over the past few years, some observers have
expressed concern about high future inflation in
advanced economies because of the huge rise in
central bank balance sheets and the sharp increase in
fiscal deficits1. These predictions of high inflation rest
on the monetarist argument that nominal income is
proportional to the money supply. The monetary
approach assumes a stable demand for real money
balances. It is argued that, given aggregate supply
constraints in the short run, an expansion of the money
supply is bound to lead to higher prices. So, the
argument goes, the unprecedented money printing by
central banks in the developed world since 2008 is a
sure harbinger of high inflation. So far, however, those
fears have not materialized. Quite the opposite, in fact,
as in most developed countries, the inflation rate
remains below or well below the official targets of the
main central banks (typically 2% or just below).
So should we be worried about high future inflation?
We would argue that the answer to that question is
negative for four main reasons. The first reason relates
to structural changes, especially globalization and the
spread of technological innovations, which are
expected to keep exerting constant downward
pressure on inflation from the supply side. The second
reason is that, since 2008, most advanced economies
have fallen into a liquidity trap (when the zero lower
bound on the central bank policy rate is strictly
binding), and suffer, as a consequence, from
chronically deficient aggregate demand. When an
economy is in a liquidity trap, the link between the
money supply and nominal GDP breaks down (or to put
it otherwise, the quantity theory of money does not
hold any more) owing to the dramatic increase in the
private sector’s willingness to hoard money instead of
spend it. The third reason concerns the lack of
evidence of a wage-price spiral. We believe that
structural trends (such as declining union influence and
rising labour-market flexibility), coupled with continued
slack in the labour market in much of the developed
world, will underpin generally sober growth in wages
(the main driver of sustained inflation) in the
foreseeable future.
And finally, with inflation dropping to very low levels,
there is a serious risk that a vicious circle of selfperpetuating economic weakness could be set in
motion that might leave much of the developed world
stuck into a low-inflation trap. Part of the reason is the
fact that low inflation increases real debt burdens and
thus weakens aggregate demand still further. Another
reason is that sticky nominal wages can prevent real
wages from adjusting downward to clear the labour
market2.
A MULTI-DECADE DOWNWARD TREND IN
INFLATION
A GLOBAL PHENOMENON
Prior to the mid-1960s, low inflation was the norm
across the developed world rather than the exception.
Inflation began ratcheting upward in the mid-1960s,
and, by the late 1970s, had reached levels unheard of
in peacetime, a reflection in part of the 1973 and 1979
oil price spikes triggered by the wars and revolutions in
the Middle East. A few countries, including the USA
and the UK, had smaller inflation bursts in 1990. But
since then, inflation has remained steadily low in all
OECD countries, with several countries experiencing
episodes of price declines, especially in the aftermath
of the global financial crisis of 2008.
INCREASED CENTRAL BANK CREDIBILITY
The downward trend and stabilization of inflation
across the developed world over the past few decades
can be partially attributed to the increased credibility of
the main central banks’ commitment to a low inflation
regime. Inflation was finally crushed in the early 1980s,
when central banks raised interest rates to whatever
level was required to achieve price stability.
1
See, for example, Feldstein Martin (2009), “Inflation is looming
on America’s horizon”, Financial Times, April 19, or, Allan H.
Meltzer (2009), “Inflation nation”, Financial Times, May 3.
2
See notably Paul Krugman (2014), “Inflation targets
reconsidered”, Draft Paper for the ECB Sintra conference, May.
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BOX 1. THE GREAT INFLATION
The high inflation that occurred between the mid-1960s and the early 1980s, which is commonly known as
the “Great Inflation”, was a defining moment of macroeconomic history. Some have characterized these
high-inflation decades as “the greatest failure of American macroeconomic policy in the post-war period”
[see Mayer (1999)3].
Explanations for the Great Inflation fall roughly into three main categories:

The bad luck view. The first type of explanations emphasizes supply shocks and the subsequent
demand response4. The unprecedented rise in commodity prices (mainly food and oil) in 1973-74 and again
in 1979-80 definitely played an important role in the Great Inflation. However, the temporary burst of price
inflation from the oil shocks could only affect the course of the long-run inflation trend to the extent that it
was followed by endogenous adjustment of the private sector and policy authorities, with central bankers
accommodating the increase in wage bargainers’ expectations of inflation (that is, wage-cost push inflation).

The monetary policy neglect view5. The second class of explanations emphasizes policymakers’ belief
in an exploitable Phillips curve trade-off, that is, the notion that policymakers could choose to permanently
reduce the unemployment rate by accepting a permanently higher inflation rate6. According to this view, the
rise in inflation from the mid-1960s through the early 1980s reflected a shift to a higher inflation target.
Eventually, however, policymakers became convinced that there was no long-run trade-off, as inflation rose
hand in hand with unemployment - a combination known as “stagflation”. As a result, they started raising
interest rates to fight inflation.

The policy mistakes view7. The third class of explanations stresses that policymakers in the 1970s
overlooked a break in the economy’s productive potential (or potential output8) and a rise in the so-called
“natural” rate of unemployment (or the level of unemployment consistent with a constant rate of inflation,
often called the non-accelerating inflation rate of unemployment or NAIRU - see Box 3). This led them to be
excessively optimistic about how low the unemployment rate could go before igniting inflation pressures
(that is, they severely underestimated the NAIRU). Natural rate misperceptions caused monetary policies to
become overly expansionary, ultimately resulting in high inflation9.
While these different views vary in their emphasis on the main causes of the Great Inflation, they all share a
common factor, i.e. monetary policy in the 1970s was, in retrospect, excessively expansionist.
3
Mayer, Thomas (1999), “Monetary Policy and the Great Inflation in the United States: the Federal Reserve and the Failure of
Macroeconomic Policy, 1965-1979”, Cheltenham, UK: Edward Elgar.
4
See, for example: Blinder, Alan S. (1982), “The Anatomy of Double-Digit Inflation in the 1970s”, In Inflation: Causes and Effects, ed. R.
Hall, pp. 261-282. Chicago: University of Chicago Press.
5
The label is from Nelson, Edward, and Kalin Nikolov (2002), “Monetary Policy and Stagflation in the UK”, Bank of England Working Paper
N°.155, May. On this strand of explanations, see, notably: Barro, Robert J. and David B. Gordon (1983), “A Positive Theory of Monetary
Policy in a Natural Rate Model”, Journal of Political Economy, XCI, pp.589-610.
6
See Phillips, A. W. H. “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom,
1861–1957.” Economica, n.s., 25, no. 2 (1958): 283–299. The empirical inverse relationship between unemployment and wages that
Phillips highlighted for the British economy up to WW1 encouraged many economists, following the lead of Paul Samuelson and Robert
Solow, to treat the so-called Phillips curve as a sort of menu of policy options between inflation and unemployment. See Samuelson, Paul
A., and Robert M. Solow (1960), “Analytical Aspects of Anti-inflation Policy”, American Economic Review 50, May, no. 2, pp.177–194.
7
See, for example: Cukierman, Alex and Francesco Lippi (2002), “Endogenous Monetary Policy with Unobserved Potential Output”, Tel
Aviv University; Cogley, Timothy and Thomas J. Sargent (2001), “Evolving Post-World War II U.S. Inflation Dynamics”, in NBER
Macroeconomic Annual, Cambridge, MA: MIT Press, pp.331-373.
8
The “potential output” is the level of output that can be produced and sold without creating pressure for the rate of inflation to rise or fall.
9
During the 1960s, there was a consensus that the natural rate of unemployment in the United States was about four percent. But the
natural rate rose in an unexpected way during the 1970s because of a large influx of new workers from the baby boom and women
entering the workforce, as new workers tend to have high frictional unemployment rates (one of the two components of the natural rate).
With actual unemployment rising during and after the recession that started at the end of 1969, and knowing that policymakers were
underestimating the natural rate, it was only natural to hold the view that the economy was operating with considerable slack, which led
the Fed to pursue aggressive monetary policy to bring the unemployment rate down.
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When Paul Volcker stepped in, in late 1979, inflation
control became the overriding objective of monetary
policy to the detriment of the employment objective.
The primacy of price stability was then accepted by
central bankers worldwide, and many governments
institutionalized their commitment to inflation control
with the creation of independent central banks. The
resulting shift toward a more restrictive monetary policy
regime provided the anchor for inflation expectations
that had been missing since the collapse of the Bretton
Woods system10.
Expectations of future inflation are important
determinants of current inflation, but they exhibit a
great deal of inertia. So establishing credibility in the
fight against inflation is crucial to defeating inflation. It
took a few years for inflation to come down after
Volcker’s decision to raise interest rates to double-digit
figures (the so-called 1979 Volcker Shock), as the
public was initially slow to accept the primacy of the
inflation objective. But as the Fed stuck to its painful
and unpopular policy of monetary restraint long enough
to demonstrate its commitment to low inflation (which
caused the economy to fall into recession and the
monthly unemployment rate to surge to 10.8%, a level
unseen since the Great Depression), the belief in its
inflation aversion ultimately became entrenched, and
the inherent inflation momentum finally reversed. Since
the early 1980s, the stronger commitment by central
banks to maintaining a low and stable rate of inflation
has been remarkably successful at keeping inflation
expectations anchored, which has removed an
inflationary bias that some have blamed for the high
inflation of the 1970s.
POSITIVE SUPPLY SHOCKS
Though central banks have claimed credit for the
disinflation that followed Volcker’s monetary squeeze
10
The collapse of Bretton Woods encompasses the events that
occurred between 1968 and 1973 and which led to the
suspension of the dollar’s convertibility into gold. By March 1973,
the unified fixed exchange rate regime had collapsed, and the
major currencies were floating against each other.
and the low inflation that characterized the postVolcker years, the role played by the combination of
globalization and the spread of technological
innovation should not be overlooked. Over the past few
decades, globalization, along with a wave of
technological innovation, has buffeted the world
economy with positive supply shocks that have to-date
exerted constant downward pressure on prices.
The success of GATT negotiations to remove trade
barriers has typically resulted in lower prices for
imported goods and thus provided competitive
discipline for domestic firms. Deregulation combined
with expanding globalization has sharply increased
competition and lowered monopoly pricing power,
while making it more difficult for advanced economies
to avoid disinflationary impulses from abroad.
Meanwhile, the entry of China and other major
emerging countries, such as India, into the global
trading system has profoundly changed how economic
processes work, especially regarding the bargaining
outcomes between buyers and sellers. The spread of
new information and communications technologies
(ICTs) has greatly improved the speed, quality and
accessibility of information flows at negligible marginal
cost, leading to heightened competition between
suppliers and retailers. And the faster and wider spread
of advanced production techniques and cost-reducing
technologies through foreign direct investment (FDI)
has included the beneficial effect of promoting
productivity and output growth.
There was a revival of productivity in many countries
during 1995-2004, which contributed to holding unit
labour costs down. Rising productivity, combined with
declining import prices and low oil prices, led to
substantial downward pressure on inflation. Meanwhile,
nominal wages remained subdued, in large part
because of the integration of China’s massive labour
force into the world economy. This profoundly changed
the balance of power between employers and
employees throughout the developed world. The
consequent rise in the global labour supply, coupled
with increased competition and the threat of
delocalization of whole factories to lower-cost
countries eroded the power of organized labour and
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constrained rises in labour compensation. Meanwhile,
rapid advances in automation technology lowered the
demand for workers in low-skilled jobs, putting
downward pressure on their wage rates. This has
contributed to lowering labour’s share of income in
many developed countries (with the notable exception
of France) over the past 25 years11. An increasing part
of the labour share of GDP has gone to the highest
earners, leading to mounting income inequality.
excessively lax over the past few decades, as the main
central bankers have increasingly found themselves
resisting “good” structural disinflationary pressures.
White (2015) argues that the US monetary policy
stance has been systematically too expansionary since
1987. The stock market crash of October 1987
prompted the Federal Reserve to lower the federal
funds rate by 50 basis points and opened an era in
which the Fed, under Chairman Greenspan, came up
with a rescue package whenever a major crisis arose
(i.e. the 1990-1991 recession, the collapse of LongTerm Capital Management, The Asian Contagion, the
bursting of the dotcom bubble and the aftermath of the
September 11 attacks)13. There have been many cycles
of monetary easing since 1987, but they have not been
matched with equal monetary tightening cycles during
the “good” times. This has caused policy interest rates
to fall towards zero and, in several countries, all the
way to the zero lower bound. Low interest rates, in
turn, have led to a sharp rise in private debt and a
surge in housing prices and in certain financial assets14.
THE GREAT MODERATION
By 2000, inflation had fallen to around 2% in many
countries of the world and it remained stable for many
years. From the mid-1980s to 2007, the economy
appeared to have entered another distinct phase in
which the level and volatility of the inflation trend and
output declined significantly (a phenomenon which
came to be known as the “Great Moderation”). The
Great Moderation has been attributed to a combination
of
factors
including
well-anchored
inflation
expectations, primarily due to improved monetary
policy performance (greater independence, better
communication strategies, etc.), structural changes in
labour and goods markets and good luck. Economists,
however, differ on what roles were played by the
different factors in contributing to the decline in trend
inflation during that period. The reason, of course, is
that determining the relative importance of structural
factors (which set the intensity of cost-push effects)
and cyclical factors (which determine the intensity of
demand-pull effects) in price setting is far from
straightforward.
Some [see, for example, White (2015)12] have argued
that the deflationary pressures stemming from
economy-wide positive supply shocks have been
misinterpreted as “bad” deflation. As a consequence,
monetary policy in the developed world has been
NEGATIVE DEMAND SHOCK SINCE 2008
The calm of the Great Moderation ended abruptly with
the global financial crisis of 2007-08. The ensuing
crash of the credit-fuelled boom prompted a cycle of
forced deleveraging of the debt-laden private sector.
This created a massive negative shock to aggregate
demand, plunging the developed world into the Great
13
During the Greenspan era (1987-2006), the provision of ample
emergency liquidity whenever financial crises came to a head
created the perception that a dramatic decline in asset prices
would always prompt the Fed to come riding to the rescue of
stock investors (if not to stock investors themselves, to the threat
to the economy that would arise from a stock market crash) to
avert further losing positions. This gave investors the confidence
that the Fed would always take decisive action to stem an
escalating financial crisis - a belief that has become known as the
“Greenspan put”.
11
See, for example, Elsby, Michael, Bart Hobijn, and Aysegül
Sahin (2013), “The decline of the U.S. labor share”, Brookings
Papers on Economic Activity, Fall.
12
William R. White (2015), “On the need for greater humility in the
conduct of monetary policy”, Remarks to VAC Munich on the
occasion of receiving the Hans-Möller-Medal for 2015, May.
14
The BIS has long argued that monetary policy-making has been
dangerously asymmetric, as central bankers have failed to lean
against the booms, while they have eased aggressively and
persistently during busts. This, it is argued, has created something
akin to a debt trap, where it is difficult to raise rates without
damaging economic growth.
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Recession. Inflation slowed sharply as the world’s
advanced economies went into a deep recession. In
2010-2011, almost all euro zone countries entered a
period of fiscal tightening which amplified the negative
demand shock created by the unwinding of
accumulated financial imbalances.
In 2011, inflation rose above the main central banks’
official 2% inflation target as global oil prices surged;
however, the spike in inflation was certainly not
dramatic. Since 2012, inflation has dropped well below
2%, reflecting the collapse in oil and commodity prices
since the summer of 2014 as well as wage stagnation
and enduring weak aggregate demand. Over the last
few years, core inflation (excluding volatile food and
energy prices) - central bankers’ preferred measure –
has been running below the 2% target in the majority of
advanced economies15.
DESPITE MANY PREDICTIONS TO THE
CONTRARY, INFLATION HAS FALLEN TO
RECORD LOWS
But, since 2008, central banks have injected huge
sums of money into their banking systems and
maintained their short-term nominal interest rates at
virtually zero. Meanwhile, governments have run large
fiscal deficits. Yet, despite many predictions to the
contrary, this has not had any material effect on
inflation. Why? The reason is that much of the
developed world has, in fact, fallen into a liquidity
trap17. An economy is in a liquidity trap when the zero
short nominal interest floor becomes a binding
constraint. Once interest rates are zero, economic
agents become indifferent about holding money and
holding bonds, and their demand for liquidity becomes
virtually endless. So banks prefer to hold excess
reserves instead of extending loans and people prefer
to hoard money rather than spending it. The result is a
fall in the velocity of money circulation (the rate at
which money changes hands) which offsets central
banks’ injection of money, preventing monetary policy
from gaining traction in the real economy.
THE RELATIONSHIP BETWEEN THE MONEY SUPPLY
AND INFLATION DOES NOT HOLD IN A LIQUIDITY
TRAP
As the Great Recession set in, the world’s main central
banks slashed their policy interest rates to virtually zero
in an effort to stimulate their economies and fight
against deflationary pressure. Once they hit the zero
bound on policy rates, the main central banks then
resorted to large-scale purchases of longer-term
private or public bonds – a process known as
quantitative easing (QE) – in order to give a further
stimulus to the economy. QE swelled the central banks’
balance sheets dramatically. Yet QE has always been a
contentious policy tool. Its critics warned of runaway
inflation and risks of financial bubbles16.
liquidity injected would migrate towards financial markets, thus
fuelling inflation in financial markets. See notably Borio, Claudio,
and Piti Disyatat (2009), “Unconventional monetary policies: an
appraisal”, BIS Working Papers n°292, November. Also see
Claudio Borio (2015), Media briefing on the BIS Annual Report
2015, 24 June.
17
15
The Fed uses the core Personal Consumption Expenditures (or
PCE) Index – which measures actual household spending - as its
yardstick.
16
Many critics worried that QE would contribute to excessive
leverage and risk-taking in financial markets and that most of the
Keynes invented the concept of the liquidity trap. See Keynes,
John M. (1936), The General Theory of Employment, Interest and
Money, Macmillan. To cite him: “There is the possibility... that
after the rate of interest has fallen to a certain level, liquidity
preference is virtually absolute in the sense that almost everyone
prefers cash to holding a debt at so low a rate of interest. In this
event, the monetary authority would have lost effective control”.
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BOX 2. MONETARISM FALTERS IN A LIQUIDITY TRAP
The classical theory of inflation, called monetarism, maintains that the money supply is the chief determinant
of price level over the long run. Monetarism is mainly associated with Nobel Prize-winning economist Milton
Friedman who famously wrote that “Inflation is always and everywhere a monetary phenomenon”18.
Monetarism came into vogue in the 1970s, and greatly influenced the US central bank’s decision to abruptly
tighten monetary policy to tame inflation in the late 1970s and early 1980s.
The foundation of monetarism is the Quantity Theory of Money. The theory is an accounting identity, which
says that the money supply, M, multiplied by the velocity of circulation of money, V, equals the general price
level, P, multiplied by the real economic output (or the total quantity of goods and services produced), Q:
M*V=P*Q.
As an accounting identity, the quantity theory of money is always true and thus uncontroversial.
The controversy arises because monetarists make the assumption that velocity (V) is relatively stable over
time, or at least predictable, which means that changes in the money supply (M) are the dominant forces
that change nominal GDP (P*Q). Moreover, monetarists believe in long-run monetary neutrality, meaning that
in the longer term real variables, like real output, real consumption expenditures, real wages and real interest
rates, are unaffected by changes in the money stock, even though, they reckon, real output (Q) may vary in
the short run due to wage- and price-stickiness (as wages and prices take time to adjust). So, monetarists
believe that the money supply is the primary determinant of nominal GDP in the short run and of the price
level in the long run.
In the 1970s, the velocity of the money supply M1 in the USA increased at a fairly constant rate, which
seemed to vindicate the short-run monetarist theory views (i.e. that the rate of growth of the money supply,
adjusted for a predictable level of velocity, determined nominal GDP). However, since the 1980s, the velocity
of money has exhibited high and unexpected shifts19 and since the second quarter of 2008 it has collapsed.
In October 2015, velocity was at 5.9, meaning that every dollar in the monetary supply was spent only 5.9
times in the economy, down from 10.7 just prior to the 2008 recession. The collapse in the velocity of money
since the Great Recession has almost entirely offset the unprecedented monetary base increase driven by
the Fed’s large money injections through its large-scale asset purchase programs. As a result, nominal GDP
(either P or Q) has hardly changed. When an economy is in a liquidity trap, the relationship between the
money supply and nominal GDP falls apart20.
18
See Milton Friedman (1956), “The Quantity Theory of Money: A Restatement” in Studies in the Quantity Theory of Money, edited by M.
Friedman. Reprinted in M. Friedman The Optimum Quantity of Money (2005), pp. 51-67.
19
The unstable behavior of the velocity of money in the 1980s primarily reflected changes in banking rules and financial innovations. In the
1980s banks were allowed to pay explicit interest on deposits, which led many people to hold their wealth in the form of interest-earning
checking accounts rather than in savings accounts, hence, a major and unexpected rise in the demand for money at banks. Moreover,
financial markets began introducing financial instruments (e.g. mutual funds) that competed with traditional bank deposits, so some people
shifted their funds to those instruments, which also weakened the link between the money supply and nominal GDP.
20
See, for example, Maria A. Arias and Yi Wen (2014), “The liquidity trap: an alternative explanation for today’s low inflation”, in The
Regional Economist, Federal Reserve Bank of St. Louis, April; Maria A. Arias and Yi Wen (2014),”What does money velocity tell us about
low inflation in the US”, Federal Reserve Bank of St. Louis, September 1; David C. Wheelock (2010), “The monetary base and bank
lending: you can lead a horse to water…”, In Economic Synopses, Federal Reserve Bank of St. Louis, Number 24.
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Economies in a liquidity trap require either deeply
negative nominal interest rates, which is virtually
impossible given the zero (or near zero) lower bound on
interest rates, or much higher inflation expectations,
which is the only way left to bring about the fall in real
interest rates that the economy would need to perform
at potential or at full employment. The problem,
however, is that it is very hard to induce expectations
of a higher future price level when the economy is
stuck at the zero lower bound.
THE RELATIONSHIP BETWEEN UNEMPLOYMENT
AND INFLATION REMAINS UNCERTAIN
Nevertheless, the Federal Reserve, at its December
meeting, was reasonably confident that inflation would
rise to its 2% target by 2018, which paved the way for
the Fed’s first rate hike since December 2008. On
December 16, the target range for the federal funds
rate was raised from 0-0.25% to 0.25-0.50% (still very
close to zero). Federal Reserve officials expect to
slowly ratchet their benchmark short-term interest rate
to above 3% in three years. A key argument in favour
of raising the benchmark interest rate was to overcome
the binding constraint on the effectiveness of monetary
policy that the zero lower bound is imposing. Higher
rates would give the Federal Reserve room to lower
interest rates when it needs to fight the next recession.
The risk of course, is that a premature increase in
nominal interest rates could lower inflation
expectations and thus raise real interest rates and stifle
economic growth.
Another factor which played a role in the Fed’s decision
to begin a new cycle of monetary tightening was the
improvement in the labour market and its implications
for inflation down the road. At 5% in December 2015,
the US unemployment rate is at the level the Federal
Open Market Committee (FOMC) thinks is consistent
with stable inflation. The usual assumption is that
inflation and unemployment move in opposite
directions, as suggested by the so-called Phillips
curve. Today, a revised version of the Phillips curve,
called the New Keynesian Phillips curve, is used by
economists to forecast inflation. Typically, the likely
path of future inflation will depend on expected inflation
and on a measure of slack, i.e. the gap between
current unemployment and the natural rate of
unemployment (or NAIRU).
The problem, though, is that the Phillips curve model
appears to have great difficulty accounting for the fact
that over the past two decades, across much of the
developed world, the core inflation rate has fluctuated
within a narrow range despite substantial volatility in
unemployment. This has led many economists to
wonder whether the Phillips curve relationship has
fallen apart21.
21
See, for example, Krugman, Paul (2014), “Inflation,
Unemployment, Ignorance”, The New York Times Blog, July 28.
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BOX 3. THE NATURAL RATE OF UNEMPLOYMENT
The “natural rate” of unemployment, which is often called the non-accelerating inflation rate of
unemployment or NAIRU, is a theoretical concept independently developed by Edmund Phelps22 and Milton
Friedman23. The natural rate is defined as the rate of unemployment at which there is no tendency for
inflation to accelerate or decelerate. It is determined by several labour market imperfections. The natural rate
is a combination of frictional and structural unemployment24 which exist even if the economy is running at
full capacity and close to its long-run potential growth rate. It is not constant, but changes over time. And as
it is not directly observable, it has to be estimated.
The natural rate hypothesis came to the fore in the mid-1970s when both inflation and unemployment rose
simultaneously, which the Friedman-Phelps model had predicted. For Friedman and Phelps, a tradeoff
between inflation and unemployment could only be achieved by tricking people about inflation and thus
could only exist in the short term. In this model, monetary stimulus used to lower unemployment below its
natural rate can only lead to accelerating inflation. As worker inflation expectations catch up with reality,
rational workers demand greater nominal wages so that their incomes will keep pace with inflation. As real
wages rise, firms cut back on their hiring and unemployment rises back to its previous level, but with higher
inflation reflecting a tight labour market and bottlenecks in production.
In the Friedman-Phelps model, the inflation-unemployment tradeoff disappears over the long term, as the
unemployment rate returns to its natural rate, regardless of the inflation rate, resulting in a vertical, long-term
Phillips curve. The analysis made by Friedman and Phelps can be summarized as follows:
Unemployment rate = natural rate of unemployment – p*(actual inflation - expected inflation)
Where p is a variable which measures how much unemployment responds to unexpected inflation.
In the short term, expected inflation is a given, so higher actual inflation is associated with lower
unemployment. But in the longer term, when expected inflation has fully adjusted to actual inflation, the
unemployment rate stands at a level uniquely consistent with a stable inflation rate—the natural rate of
unemployment or NAIRU. While monetary stimulus cannot decrease unemployment in the long run,
microeconomic policies can lower the NAIRU itself by removing labour market imperfections.
In the aftermath of the stagflation of the 1970s, theories based on the natural rate of unemployment largely
displaced the earlier view that a permanent tradeoff existed between inflation and unemployment. The idea
that there was no long-run relationship between inflation and unemployment became the paradigm in
monetary economics. As the belief in a short-run tradeoff between inflation and unemployment continued to
prevail, estimating the NAIRU became part of the core business of central banks25.
22
Phelps, Edmund S. “Phillips Curves, Expectations of Inflation and Optimal Employment over Time.” Economica, n.s., 34, no. 3 (1967):
254–281.
23
Friedman, Milton. “The Role of Monetary Policy.” American Economic Review 58, no. 1 (1968): 1–17.
24
“Frictional” unemployment occurs because finding a job takes time while “structural” unemployment arises from various factors such as
skill mismatch, location mismatch, institutional barriers (minimum wage laws, etc.), imperfect information flows or public transfer programs
(which reduces the incentive to search for a job).
25
See e.g. Laurence Ball, N. Gregory Mankiw, and David Romer (1988), “The new Keynesian economics and the output-inflation tradeoff”, Brookings Papers on Economic Activity, 19, pp.1-82.
9
ECONOTE | N°30 – MARCH 2016
So the hot question currently being debated in the USA
is if inflation will start to increase soon given that the
economy is entering the NAIRU zone26. So far, wage
pressures in America have remained subdued,
contributing to keeping core inflation (excluding the
transitory effects of supply shocks) in check.
At this point, there are few signs that rising wages will
soon start to push inflation higher in the US or most
other developed countries.
The lack of meaningful wage growth is evident in the
great majority of developed countries despite a
declining unemployment rate in many countries.
Real wages for most workers continue to stagnate or
fall across the developed world.
Some analysts believe that, with unemployment at the
NAIRU, wage growth and inflation in America is about
to start accelerating27. Yet others argue that this
remains subject to large uncertainties. The question of
whether there is still slack in the labour market remains
indeed a matter of considerable debate. While some
believe that the slack in the US labour market has been
eliminated, others contend that the decline in the
unemployment rate masks continued weakness. The
latter emphasize, in particular, falling labour force
participation – down from 66% in July 2008 to 62.9%
in February 2016 – or the large number of part-time
workers, while arguing that people who have left the
formal workforce but still want a job, or people who
would like a full-time job but can only find part-time
work, may hold down wages by enhancing competition
among job seekers28.
Quite apart from that, many analysts point out the
structural shifts that have taken place in the labour
market in recent decades to argue that wage growth
will remain sluggish for the foreseeable future across
much of the developed world. Arguably, the diminished
influence of organized labour (owing to increased
global competition and/or legal reforms), as well as the
rising flexibility in the labour market (with a rising share
of part-time, temporary and zero-hours contracts) will
keep bearing down on wage growth in the years ahead.
These trends have created an environment which is
very different from that which generated cost-push
inflation in the 1970s by making it much easier to
restrain pay raises. This has been reflected in a
declining labour share of GDP in the United States, as
wages have not been improving in line with
productivity. The decline in labour productivity growth
that has been observed in many developed countries
since 2008 has only made matters worse.
27
26
For a summary of the argument see notably Gavyn Davies
(2016), « Splits in the Keynesian camp: a Galilean Dialogue »,
Financial Times, February 21.
So the argument goes that as idle labour becomes scarce, firms
will raise wages to attract scarce labour, which will push
consumer prices higher, as businesses act to protect their profit
margins given that wages are a significant fraction of their
production costs.
28
See, for example, Federal Reserve Bank of Atlanta (2014),
“Jobs: More work to be done?”, Annual Report.
10
ECONOTE | N°30 – MARCH 2016
BOX 4. THE “MISSING DEFLATION PUZZLE”
The debate over the relevance of the Phillips curve has gained momentum since the Great Recession, as
inflation has not fallen as much as the standard Phillips curve model predicts29. Given the surge of
unemployment to high levels, the model typically predicts deflation, but most developed countries have
exhibited low core inflation, rather than deflation, hence the so-called “missing deflation puzzle”30. This has
led a number of observers to wonder whether the Phillips curve relationship has in fact broken down.
Many economists have put forward possible explanations for why most advanced economies have not seen
deflation since 2008. Three basic ideas have stood out, leading to revised versions of the Phillips curve. The
first idea is that inflation expectations have become well-anchored, owing mainly to central bank credibility31.
The argument is that the central banks’ inflation target of 2% has kept expected inflation near 2% which has
prevented actual inflation from falling far below that level.
The second idea is that the short-run rate of unemployment is a better predictor of inflation than the
aggregate unemployment rate (used in the typical Phillips curve)32. This is because, the argument goes, the
long-run unemployed do not put downward pressure on wages, either because they do not search
intensively for work or because employers tend to view them as “unemployable”. During the Great
Recession, short-term unemployment rose less sharply than total unemployment and has since returned to
pre-recession levels. Gordon (2013) hypothesized that the rising importance of long-run unemployment
(spells of 27 weeks or more) has caused the NAIRU in the US to rise - from 4.8% in 2006 to 6.5% in 2013 –,
suggesting that the labour market may be operating with less slack than is generally assumed, hence the
lack of deflation as well as the nascent inflation threat. The suggestion that only the short-term
unemployment rate matters for wage determination has been gaining increasing attention in policy circles.
The third idea is that most advanced economies exhibit downward nominal wage rigidity due to great
resistance to cuts in nominal pay, and that this has prevented inflation from falling into negative territory.
Daly and Hobijn (2014) argued that, during recessions, downward nominal wage rigidities become more
binding, leading to disproportionate adjustment through unemployment rather than through wages33.
29
This followed the failure of the traditional Philip’s curve to explain the positive relationship between inflation and unemployment in the
mid-1970s and the decline in inflation despite low unemployment in the 1990s.
30
See notably Laurence Ball and Sandeep Mazumder (2011), “Inflation Dynamics and the Great Recession”, Brookings Papers on
Economic Activity (Spring), pp.337-381.
31
See notably Bernanke, B. (2010), “The economic outlook and monetary policy”, Speech at the Federal Reserve Bank of Kansas City
Economic Symposium, Jackson Hole, Wyoming, and International Monetary Fund (2013), “The dog that didn’t bark: Has inflation been
muzzled or was it just sleeping?”, World Economic Outlook. Also see Laurence Ball and Sandeep Mazumder (2015), “A Philips curve with
anchored expectations and short-term unemployment”, IMF Working Paper WP/15/39, February.
32
See Robert J. Gordon (2013), “The Philips curve is alive and well: Inflation and the NAIRU during the slow recovery”, National Bureau of
Economic Research, Working Paper n°19390, August. Also see Krueger, A., T. Cramer and D. Cho (2014), “Are the long-term unemployed
on the margins of the labour market?”, Brookings Panel on Economic Activity, March; Watson, M. W. (2014), “Inflation persistence, the
NAIRU and the Great Recession”, American Economic Review (Papers and Proceedings), May; Linder, H. M., R. Peach and R. Rich (2014),
“The long and short of it: The impact of unemployment duration on compensation growth”, Liberty Street Economics, Federal Reserve
Bank of New York.
33
See notably Daly, Mary C. and Bart Hobijn (2014), “Downward nominal wage rigidities bend the Philips curve”, Federal Reserve Bank of
San Francisco, Working Paper 2013-08, January.
11
ECONOTE | N°30 – MARCH 2016
policy rates substantially below zero36. Low inflation
exacerbates the problems posed by these two lower
bounds.
Another reason why wage gains may remain slow and
fragile for a while lies in “pent-up wage deflation”34.
Daly and Hobijn (2014) argued that firms, which were
generally unable to cut wages during the Great
Recession, later compensated by withholding raises
during the recovery35. The argument states that, during
recessions, downward nominal wage rigidities imply
that wage inflation remains higher than the rate that
would occur if nominal wage levels were fully flexible
and could be reduced, hence the emergence of
substantial pent-up wage deflation. As the economy
recovers, and unemployment falls, the downward
pressure on wages diminishes. But the stockpile of
pent-up wage deflation accumulated during the
recession must be disposed of before the labour
market can return to equilibrium. As long as the pool of
wage cuts is not entirely exhausted, firms will wait for
inflation and productivity growth to bring wages closer
to their desired level rather than raise nominal wages.
So, during that period, wage growth remains low even
though the unemployment rate is declining. Downward
nominal wage rigidity causes the short-term Phillips
curve to flatten [see Daly and Hobijn (2014)]. The big
question now is, at what stage of the adjustment
process are we?
THE ECONOMICS OF LOW INFLATION
Low inflation increases rigidity in the labour market37.
Evidence of the great resistance to cuts in nominal
wages, even in recessionary periods with very high
unemployment, abounds across much of the
developed world. Sticky nominal wages, coupled with
low inflation, mean that higher-than-desired real wages
further reduce the demand for workers, contributing to
higher and more enduring unemployment than would
occur if inflation were, say, 3-4 percent. This is
because a certain amount of inflation “greases the
wheels” of the labour market as workers are typically
less opposed to the erosion of their real wages by
inflation. As Tobin (1972) pointed out38, downward
nominal wage rigidity at very low rates of inflation
implies a Phillips curve that is not vertical, even in the
long run. This suggests that the rate of inflation may in
fact have a lasting influence on the rate of permanent
employment at which the economy eventually settles.
Very low inflation in a sticky-wage world may cause
permanently high unemployment, which may, in turn,
prevent workers from obtaining higher wages.
Low inflation also constrains real interest rates in a
crucial manner. As seen above, the nominal interest
rate cannot fall much below zero because that would
THE PROBLEM OF THE TWO ZERO LOWER BOUNDS
Is the developed world about to return to normality,
with declining unemployment leading to sustained
wage inflation eventually triggering central-bank
interest-rate hikes? This appears highly unlikely. Part of
the reason lies in two (not absolute) zero lower bounds,
namely, the great difficulty of cutting nominal wages
and the impossibility for central banks to reduce their
34
The term was coined by Daly, Mary C. and Bart Hobijn (2014)
(op. cit. note 28).
35
Daly, Mary C. and Bart Hobijn (2014) (op. cit. note 28). Also see
Daly, Mary C. and Bart Hobijn (2015), “Why is wage growth so
slow?”, Economic Letter, Federal Reserve Bank of San Francisco,
January 5.
36
See notably Krugman, Paul (2014), “Lowflation and the two
zeroes”, The New York Times Blog, March 5. Also see Krugman,
Paul (2013), “Not enough inflation”, The New York Times Blog,
May 2, 2013.
37
See Akerlof G.A, Dickens WT, Perry WL (1996), “The
macroeconomics of low inflation”, Brookings Papers on Economic
Activity 1, pp.1-75; Akerlof G.A, Dickens WT, Perry WL (2000),
“New rational wage and price setting and the long-run Phillips
curve”, Brookings Papers on Economic Activity 1, pp.1-60;
Dickens, WT. (2010), “Has the recession increased the NAIRU?”,
mimeo, Northeastern University; Schmitt-Grohe, S. and M. Uribe
(2012), “The making of a Great Contraction with a liquidity trap
and a jobless recovery”, NBER Working Paper n°18544.
38
Tobin James (1972), “Inflation and unemployment”, American
Economic Review 62, pp.1-18.
12
ECONOTE | N°30 – MARCH 2016
prompt people to withdraw their deposits from banks
and sit on cash hoards. Together with low inflation, this
means that there is no room left for monetary policy to
reduce interest rates in the face of adverse demand
shocks. So, low inflation increases the probability that
the effective lower bound on nominal interest rates will
bind and, thus, enhances the risk that the real interest
rate may not be able to fall far enough to generate
sufficient aggregate demand to allow the economy to
perform at potential. Today, seven years after the onset
of the Great Recession, the still-wide negative output
gaps that much of the developed world exhibits is
testimony to the enduring shortfall of aggregate
demand. The failure of the real interest rate to fall to its
equilibrium value induces a chronic shortage of
aggregate demand which may cause the economy to
remain stuck in stagnation for an indefinite length of
time.
THE DEBT OVERHANG PROBLEM
Another challenge from very low inflation arises from
Fisher-type debt deflation. Fisher (1933) famously
argued that sustained deflation can be highly
destructive to the economy because it worsens the
balance sheets of debtors by increasing the real
burden of their debt. This can set off a selfperpetuating feedback loop between falling inflation,
rising debt burdens and weakening spending39.
Moreover, deflation redistributes income from debtors
to lenders, but as lenders have a higher propensity to
save than debtors, the result is that demand growth is
further sapped overall. Importantly, these Fisherian
debt deflation mechanisms are not only triggered by
outright deflation, but can also arise when inflation is
running below expectations, as shown by the IMF
(2014)40. This perverse loop between debt and low
inflation has undoubtedly been a substantial factor
behind the slow and painful deleveraging process the
developed world has experienced in the aftermath of
39
Fisher, Irving (1933), “The debt-deflation theory of Great
Depressions”, Econometrica, 1(4).
40
See Moghadam, Reza, Ranjit Teja and Pelin Berkmen (2014),
“Euro area – 'Deflation' versus 'Lowflation'", IMF Direct, March 4.
the global financial crisis. These vicious effects are, of
course, more intense in a deflationary world than in a
low-inflation environment.
Japan’s experience with deflation has so far turned out
to be pretty much unique, thanks to well-anchored
inflation expectations and sticky nominal wages in
most developed countries41. Could collapsing oil prices
upset this state of affairs? With inflation already close
to zero, falling oil prices often causes inflation to fall
below zero. But, conversely, it gives extra purchasing
power to importing countries, which can stimulate
demand. It is however possible that these positive
demand effects are slower to materialize than during
previous oil counter-shocks: because of past excesses
private agents may have indeed a tendency to use this
extra purchasing power to deleverage more quickly
instead of spending more.
TODAY THE DANGER ARISES FROM TOOLOW INFLATION
INFLATION AND DEFLATION: FROM ONE EVIL TO
ANOTHER?
The conventional macroeconomic wisdom of the past
few decades was that high and variable inflation has
costs. These costs stem largely from the fact that
inflation erodes the purchasing power of money and
redistributes income haphazardly. However, Barro
(1997) – in one of the most influential studies in this
body of literature – found that, based on a panel of
about 100 countries between 1965 and 1990, there
was no evidence that inflation rates below 10-15%
41
It is worth emphasizing that, although downward nominal wage
rigidity becomes a serious constraint if the relative wages of large
groups of workers “need” (in a market-clearing sense) to fall, it has
the beneficial effect of warding off destructive deflation. Sticky
nominal wages may create supply-side difficulties if wages are
stuck above the equilibrium wage rate thus, other things being
equal, causing unemployment. But downward nominal wage
rigidity also helps counter the risk of deflation, hence alleviating
the aggregate demand problem stemming from debt deflation
mechanisms.
13
ECONOTE | N°30 – MARCH 2016
were harmful for real growth42. Empirical research has
yielded no conclusive findings regarding the
quantification of the impact of inflation on economic
performance [see, for example, Bernanke, Laubach,
Mishkin and Posen (1999)43].
As for deflation, there is a distinction to be made
between “good” and “bad” deflation. Good deflation
typically arises from positive supply shocks (such as
technological innovations) that cause aggregate supply
to increase more rapidly than aggregate demand.
When deflation reflects rapid productivity growth, as in
the late nineteenth century, it can go hand in hand with
rising real incomes and positive economic growth44.
But that is in sharp contrast with the experience of
deflation during the Great Depression or in Japan in the
aftermath of its asset price bubble, when prices were
falling because of a slump in aggregate demand.
If deflation is caused by declines in aggregate demand
that outpace rises in aggregate supply, it can have
deleterious effects on the economy. This is because, in
a deflationary environment, consumers and businesses
tend to delay spending and investment decisions in
anticipation that prices will continue dropping, which
can lock economies into a downward spiral of demand
and prices. Adding the fact that falling prices increase
the real burden of existing debt and may prevent the
central bank from pushing nominal interest low enough
to close the gap between actual and potential output,
deflation appears to be a sure-fire recipe for long-term
economic stagnation and self-perpetuating low
inflation. And as Japan has shown, once entrenched,
deflation is hard to defeat.
PENDULUM
SWINGING
TOWARDS
FEAR
are likely to be far smaller than the long-run costs of
allowing inflation to rise to double or triple digits. This is
why some observers argue today that inflation could
become a danger if the Fed failed to respond
adequately to the fall in unemployment. There are
certainly few signs of a wage-price spiral today, but, so
goes the argument, wages are a lagging indicator. If
they wait too long, central bankers may find
themselves “behind the curve” with regard to winding
down the extraordinary amount of monetary stimulus
as inflation returns. Then, before you know it, the
spectre of 70s-style stagflation (or even Weimar
hyperinflation) may be back.
The pendulum tends to swing back and forth. The
Great Depression of the 1930s imparted an inflationary
bias to fiscal and monetary policy. Then, fighting
inflation became the overwhelming priority in the wake
of the Great Inflation of the 1970s, as deflation was the
furthest thing from anyone’s mind. Now, the pendulum
has swung back and we are again facing a deflation
scare. The main danger today doesn’t come from
inflation threatening to reach unacceptably high levels,
but from excessively low inflation.
OF
DEFLATION
The generation of policymakers who lived through the
1970s learned that inflation breeds great evil and that
steps should be taken to prevent it from getting out of
control. The prevailing orthodoxy among central
bankers in the past forty or fifty years has been that the
short-term costs of unemployment and lost output due
to pre-emptive action to stem inflation in its incipiency
42
Barro, Robert (1997). Determinants of economic growth: A
cross-country empirical study. Cambridge, MA: MIT Press.
43
Ben Bernanke, Thomas Laubach, Frederic Mishkin, and Adam
Posen (1999). Inflation targeting: Lessons from the international
experience. Princeton, NJ: Princeton University Press.
44
Borio et al (2015) found that, based on a panel of 38 countries
over the past 140 years, the historical link between output growth
and deflation was weak and derived largely from the Great
Depression. According to these authors, the link between output
growth and asset price deflations was stronger. See Claudio
Borio, Magdalena Erdem, Andrew Filardo and Boris Hofmann
(2015), “The costs of deflations: a historical perspective”, BIS
Quarterly Review, March.
14
ECONOTE | N°30 – MARCH 2016
PREVIOUS ISSUES OF ECONOTE
N°29 Low interest rates: the ‘new normal’?
Marie-Hélène DUPRAT (September 2015)
N°28 Euro zone: in the ‘grip of secular stagnation’?
Marie-Hélène DUPRAT (March 2015)
N°27 Emerging oil producing countries: Which are the most vulnerable to the decline in oil prices?
Régis GALLAND (February 2015)
N°26 Germany: Not a “bazaar” but a factory!
Benoît HEITZ (January 2015)
N°25 Eurozone: is the crisis over?
Marie-Hélène DUPRAT (September 2014)
N°24 Eurozone: corporate financing via market: an uneven development within the eurozone
Clémentine GALLÈS, Antoine VALLAS (May 2014)
N°23 Ireland: The aid plan is ending - Now what?
Benoît HEITZ (January 2014)
N°22 The euro zone: Falling into a liquidity trap?
Marie-Hélène DUPRAT (November 2013)
N°21 Rising public debt in Japan: how far is too far?
Audrey GASTEUIL (November 2013)
N°20 Netherlands: at the periphery of core countries
Benoît HEITZ (September 2013)
N°19 US: Becoming a LNG exporter
Marc-Antoine COLLARD (June 2013)
N°18 France: Why has the current account balance deteriorated for more than 20 years?
Benoît HEITZ (June 2013)
N°17 US energy independence
Marc-Antoine COLLARD (May 2013)
N°16 Developed countries: who holds public debt?
Audrey GASTEUIL-ROUGIER (April 2013)
N°15 China: The growth debate
Olivier DE BOYSSON, Sopanha SA (April 2013)
N°14 China: Housing Property Prices: failing to see the forest for the trees
Sopanha SA (April 2013)
N°13 Financing government debt: a vehicle for the (dis)integration of the Eurozone?
Léa DAUPHAS, Clémentine GALLÈS (February 2013)
N°12 Germany’s export performance: comparative analysis with its European peers
Marc FRISO (December 2012)
N°11 The Eurozone: a unique crisis
Marie-Hélène DUPRAT (September 2012)
N°10 Housing market and macroprudential policies: is Canada a success story?
Marc-Antoine COLLARD (August 2012)
N°9
UK Quantitative Easing: More inflation but not more activity?
Benoît HEITZ (July 2012)
15
ECONOTE | N°30 – MARCH 2016
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