The biggest threat to the global economy is an excessively low rate of inflation—what our economists are calling “lowflation”—that has lingered amid the weak recovery from the Great Recession, sapping demand and confidence and muting growth prospects.
Amid more recent signs that lowflation could morph into outright deflation, central bankers around the world have moved aggressively to counter its effects. The battle against lowflation in 2015 is shaping economic trends and could determine whether the current global expansion sputters, or ramps into one of the longest on record.
To the average consumer, a low rate of inflation may seem more windfall than wolf whistle. We intuitively grasp the perils of hyperinflation and can understand why deflation can signal overall demand so weak that it can send an economy into a downward spiral. But why is lowflation economic enemy No. 1? Isn’t that what economists and policy makers have strived to lock in?
Indeed, central banks often set their sights on a Goldilocks level of inflation, for example, 2% for the US, that is deemed just right to support growth. Lowflation marks the point at which prices are rising at well below that target rate for months, even years, persistently teetering on the edge of deflation. At this level, lowflation can exert its own steady, downward pull, all the more insidious because it can be so low-key and off-the-radar.
Economists have mapped out three major side effects from lowflation: the higher cost of repaying loans for those who hold a lot of debt; the inability to cut real interest rates when nominal rates are near, or at, zero; and the damage to central banks’ credibility as they fail to meet inflation targets and start to run out of policy options.
Early in 2015, the battle against lowflation has grown more urgent. Plunging oil prices, from above $100 a barrel in June, 2014, to around half that a month into 2015, coupled with currency market volatility and broader disinflationary pressures, have exacerbated the lowflation trend. And that has heightened fears of an even more intractable enemy: deflation.
Central Banks Fight Back
Central bankers around the world have taken up the challenge. In early January, India and Peru unexpectedly cut their interest rates. The Swiss National Bank followed with its even more surprising move to abandon the Swiss franc’s peg to the euro, foreshadowing the European Central Bank’s announcement of quantitative easing, or QE, an asset-buying program that would inject some €60 billion into European markets every month. This effective expansion of the money supply has caused the euro to depreciate sharply against the dollar and other major currencies, thereby countering lowflationary undercurrents.
Other major central banks have followed suit, either with rate cuts (Denmark, Canada, Sweden) or by putting plans to raise interest rates on hold (Bank of England). Sweden’s central bank even announced its own mini-QE program. So far, the Federal Reserve has held to its guidance that it expects to start raising its key interest rate, which has hovered near zero since 2008, around the middle of this year. But an alarmingly rapid ascent of the US dollar has tightened financial conditions and pushed inflation further away from the 2% goal, all at a time when the expansion is strengthening but still fragile. Morgan Stanley Chief US Economist Ellen Zentner forecasts that the global headwinds of lowflation are now likely to delay the Fed’s first rate increase to early 2016.
The intensity of the global response to lowflation has sent shockwaves through financial markets. So far, the early signs appear to be positive. While the battle isn’t over, and more monetary and macro policy skirmishes lie ahead, central banks are likely to succeed eventually, and lowflation will give way to reflation and healthier, more sustainable overall growth.
In this case, the current global economic expansion, while not yet particularly robust, may go down as one of the longest on record.
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