Small Business bannerSmall Business Centre
http://www.canadianbusiness.com (© Rogers Digital Media 2014, All Rights Reserved.)
Updated: Tue, 07 Jan 2014 09:10:00 GMT | By Erica Alini

Why is U.S. inflation so low?

A few ideas from Erica Alini


CB_Ben_Bernanke_QE_FEATURED

When the Federal Reserve announced it would shave $10 billion off its next round of purchases of asset-backed securities and U.S. Treasurys, the markets cheered. Presumably, that’s because investors interpreted the taper as a sign that Ben Bernanke thinks the economy is finally on the path to decent growth. But if things are looking up, why is inflation so dreadfully low?

There are several schools of thought on the matter:

Inflation is low because of an ingenious new Fed policy. In 2008, writes Martin Feldstein , the Fed started doing something it hadn’t done before: Paying interest on the excess reserves of commercial banks.

Let me explain. Banks are required to hold a certain percentage of customers’ deposits at the Fed. It used to be that if the banks parked money at Fed beyond the required amount, they wouldn’t earn any interest on it, giving them an incentive to lend out anything they could to businesses and households. That, though, changed in 2008. Feldstein and others argue that paying interest on excess reserves gave the banks a reason to pile up money at the central bank rather than let Americans borrow it. This, goes the theory, allowed the Fed to mop up the extra money it has been printing to stimulate the economy. Had that extra money been allowed to circulate through the economy, it would have pushed up prices. This way, it didn’t.

Catch: This doesn’t really explain why inflation at one point shot past the Fed’s target of 2% - it averaged 3.2% in 2011 - and then started slowing.

Inflation is low because the economy is still struggling. A vast cadre of economists has been arguing that stubbornly low price growth is a predicament of slow-growing economies. America’s GDP is expanding, but still at a moderate rate, they say. Businesses have plenty of spare capacity and high inventories. American workers are facing high unemployment and slow or no wage growth. Neither can afford higher prices.

Catch: Things might not be good yet for the U.S. economy, but they’re certainly been looking up, both in terms of GDP growth and labour market conditions. Shouldn’t inflation be inching up as well?

Inflation is low because the U.S. is importing inflation from abroad. The price of U.S. services, which is mostly tied to domestic factors, has actually been growing around and even above the Fed’s target of 2% for the past two years (hat-tip to Barry Knapp at Barclays Capital ). It’s the price of goods that has been plummeting. There are couple of obvious reasons for that: Lower commodity and energy prices, plus cheaper imports from recession-stricken Europe as well as Japan, where Abenomics has severely weakened the yen.

Catch: Inflation looks low even when you take out food and energy, two very big components of the consumer goods’ basket that are heavily influenced by commodity prices. Also, Europe might still be in dire straits, but the Euro has been strengthening throughout 2013, which should have cancelled some of the disinflationary pressures coming in via imports.

Conclusion? As St. Louis Fed President James Bullard said : “There is no widely accepted reason why inflation is running as low as it is in the face of extraordinarily accommodative policy from the Fed.” And, I might add, in the face of improving economic conditions as well.

Erica Alini is a reporter based in Cambridge, Mass., and a regular contributor to CanadianBusiness.com, where she covers the U.S. economy.

Follow @ealini

More stories from Canadian Business

Scroll upScroll down

Recently recommended stories

advertisement