It is 25 years since I wrote my book The Death of Inflation. Throughout this period I have constantly asked myself whether the conditions that produced low inflation were about to change and whether the time was right to forecast inflation’s imminent rebirth.
In the event, I never did reverse my call and, despite the occasional spike, overall inflation has remained very subdued. But in the past two weeks something has occurred to make me think that a resurgence of inflation may not be that far off.
This is not to say that inflation is about to take off in the immediate future. Quite the opposite. As it happens, the latest UK inflation figures will be published this Wednesday. Thanks to a combination of temporary factors, the inflation rate may fall back from last month’s 0.6pc to somewhere near zero.
Indeed, there is a good chance that the rate could even dip into negative territory. In coming months inflation will probably move up to somewhere just below its 2pc target, but not more. For the next couple of years, the depressed economy, including a very weak labour market, should ensure that inflation stays low.
But later it could be an altogether different story. Although all sorts of supply-side shocks can dominate the inflation out-turn in the short term, in the long term it depends most of all upon the policy regime operated by the authorities.
The recent development that has caused my inflationary antennae to twitch was the change of policy regime announced by the Federal Reserve, America’s central bank. Up to now, in common with other central banks, the Fed’s policy regime was to try to achieve inflation of 2pc at all times. The new policy, however, is to aim to get inflation to 2pc on average over a run of years.
This may sound like a minor technical change but it is potentially momentous. Under the old inflation target, whatever happened to inflation in previous periods had no bearing on the central bank’s target for the future. So, if inflation persistently undershot the 2pc target, in subsequent periods the Fed would still be aiming for inflation of 2pc.
Under the new regime, however, if inflation persistently undershoots, then the Fed will aim for inflation above 2pc in the succeeding period. It has been persistently under-shooting. So the conditions are in place for the Fed to aim for inflation significantly above 2pc – at least for a while.
And there has been another tweak to the policy regime. The Fed will no longer seek to nip inflationary pressures in the bud by raising interest rates in advance of an inflationary upsurge. Under the new regime, inflation will need to be visibly on the up before the Fed will raise rates.
This change of regime suggests that once aggregate demand revives and the economy returns to something like normal, we should expect inflation to lodge for a time above 2pc without an immediate policy response from the Fed. In other words, we should expect real interest rates to be even more negative than they are now.
This could bring some major benefits. Heavily negative real rates, continuing for some time, should help to keep aggregate demand strong, and both a strong economy and a little bit more inflation would start to erode the debt ratio.
You might be able to guess where this is leading. Often major policy changes do not happen starkly overnight. Rather, there is an edging away from one regime and towards another. Suppose the US does experience a few years of inflation at about 3pc, with interest rates still at about zero, and therefore heavily negative in real terms, and with the long bond yield anchored by continued bond purchases by the Fed.
Would there be the appetite to change this policy when a few years of running with inflation above 2pc has fully compensated for the inflation undershoot of previous years? I suspect not. In other words, I wonder whether we can see now on the horizon the beginnings of a regime where the Fed actively seeks to get inflation running at a level significantly above 2pc, not just for a year or two but as the norm.
Of course, just because central banks want inflation to be above 2pc doesn’t mean to say that they will achieve this. After all, recently they haven’t been able to get inflation up to the 2pc target.
But there are some differences from the situation that existed before the coronavirus crisis. For a start, there has been unprecedented monetary easing, with both interest rates at all-time lows and massive injections of liquidity. The Japanese experience of persistently failing to get inflation up to 2pc could prove to be extremely misleading.
Not only have the Japanese authorities repeatedly resorted to fiscal tightening prematurely but there were substantial structural reasons for aggregate demand to be weak. Meanwhile, the central bank was never prepared to inject enough liquidity to shift the economy out of this situation.
Here the economic fundamentals are similar to the position that confronts the US authorities. But the Bank of England is obliged to follow a mandate set by the Chancellor of the Exchequer, which, at the moment, obliges it to target an inflation rate of 2pc at all times. For the Bank to operate differently, this mandate would have to be changed.
But that does not sound to me as though it would be beyond the wit of man. After all, we have changed the inflation targeting regime before. And if we see a different regime being successful in the US, then there must be a good chance of it being adopted here as well.
Would the authorities succeed in pushing inflation higher? If they did, would this be a good thing? And could they stop inflation from accelerating to higher rates? These are subjects for another day. But for now, note this: you have been warned.
Roger Bootle is chairman of Capital Economics [email protected]