A Closer Look at the Reasons for Low Inflation

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The U.S. and other developed countries have been experiencing low inflation in recent years. A recent article in the Regional Economist explored possible reasons for this phenomenon.

Research Officer and Economist Juan Sánchez and Senior Research Associate Hee Sung Kim explained that there are reasons to be concerned about very low inflation.

If price increases remain below the central bank’s inflation target, they wrote, it may signal one of two things:

• The central bank doesn’t have inflation under control
• That its commitment to the target isn’t very strong

Low inflation also could raise the risk of falling into deflation, in which the nominal wages and the prices of consumer goods and services decline on average. Deflation is associated with weak economic conditions, according to the authors.

Technological Change

Sánchez and Kim said that many economists believe that technology advancements have helped drive down prices of goods that use the new technologies intensively. An example of this is smartphones reducing the demand for other gadgets, such as cameras

Technology also has increased labor productivity, thereby reducing unit labor costs, they noted. In a statistical analysis of the relationship between nonfarm labor productivity and inflation, an increase in labor productivity of 3 percentage points is associated with a reduction of inflation by about 2 percentage points, according to the authors.

Yet, productivity has slowed down in recent years. So why is inflation still low?

The Sharing Economy

Economists are studying a new wave of technological progress that has been dubbed the “sharing economy.” Though there is no exact definition of the term, the sharing economy usually refers to the idea of a crowd-based market that allows the exchange of privately owned goods and services. Prime examples are car-sharing company Uber or home-sharing firm Airbnb, according to Sanchez and Kim.

“Although it is not easy to see this in the official productivity statistics, it is clear that the rise of the sharing economy has improved productivity by allowing for the utilization of otherwise idle goods and services, which then has led to the reduction in prices,” they wrote.

The authors cited a paper by economists Georgios Zervas, Davide Proserpio and John Byers that looked at the introduction of Airbnb into the Texas market. Zervas, Georgios; Proserpio, Davide; and Byers, John W. “The Rise of the Sharing Economy: Estimating the Impact of Airbnb on the Hotel Industry.” Journal of Marketing Research, 2017, Vol. 54, No. 5, pp. 687-705. The three economists estimated that a 10 percent increase in Airbnb rooms is associated with a 0.39 percent decrease in hotel room revenue.

Demographic Transition

As the world’s population gets older, economists also are exploring the impact of changing demographics on inflation.

The authors noted a study by economists Shigeru Fujita and Ippei Fujiwara, who looked at deflationary pressure in Japan. Fujita and Fujiwara hypothesized that a growing share of old workers who lose their jobs also lose skills that are very specific to the firms where they worked. Fujita, Shigeru; and Fujiwara, Ippei. “Aging and Declining Trends in the Real Interest Rate and Inflation: Japanese Experience (PDF).” Unpublished manuscript, August 2015. This, in turn, forces these workers to seek entry-level jobs, which hurts wages of younger workers and creates deflationary pressure in the long run.

While the deflationary impact of an aging population appears clear, economists disagree on the question of whether a declining birthrate has a deflationary or inflationary impact.

Has demographic change affected U.S. inflation? Looking at the U.S. population from 2010 to 2016, the authors found that an increasing old age dependency ratio (the share of population age 65 and older) and a decreasing young age dependency ratio (the share of population age 14 and younger) are associated with a 0.1 percentage point decrease in inflation annually, according to Sánchez and Kim.

“Since inflation was lower than the target by 0.4 percentage points on average during that period, about 25 percent of the difference could be accounted for by the changes in demographics since 2010,” they wrote.

Other Considerations

Globalization

Some economists believe that globalization has helped pulled down inflation, though others have found little evidence that the internationalization of goods and financial markets affects domestic inflation.

Inflation Targeting

The authors explored whether central banks themselves might be a cause of this bout of low inflation. They noted that a growing number of central banks use inflation targeting since it was first introduced by New Zealand in 1989. (With inflation targeting, a central bank sets a publicly announced target for inflation and steers monetary policy to hit that target.)

“Although inflation targeting does not necessarily imply inflation that is too low, the fact that inflation lower than the target is often considered better than inflation higher than the target may contribute to an inflation rate that, on average, is lower than the target,” the authors posited.

Central Bank Independence

Another possible factor is central bank independence, which allows the monetary authority to set policy without interference. Independence allows a central bank to focus on inflation. Economists Alberto Alesina and Lawrence Summers have found evidence that suggests countries with more independent central banks are associated with low inflation. Alesina, Alberto; and Summers, Lawrence H. “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence.” Journal of Money, Credit and Banking, 1993, Vol. 25, No. 2, pp. 151-62.

Neo-Fisherism

Other economists also argue that inflation remains low due to the Fisher relationship, which says that nominal interest rates can be approximated by the sum of the real interest rate and the expected inflation rate. These economists believe that when central banks keep the policy rate (its target for the short-term nominal interest rate) close to zero for a long period of time, the Fisher relationship means that the expected inflation rate is equal to the negative of the real rate. For more on the Fisher relationship, see Williamson, Stephen. “Neo-Fisherism: A Radical Idea, or the Most Obvious Solution to the Low-Inflation Problem?” Regional Economist, 2016, Vol. 24, No. 3, pp. 5-9.

“Thus, if the real rate is close to zero, it must be that, under this hypothesis, expected inflation is close to zero as well,” they wrote. “The solution to low inflation in this context is to increase the nominal interest rate.”

Conclusion

There appear to be several factors pushing down inflation in the U.S. and other developed countries, the authors wrote.

“The new sharing economy and the demographic transition come up as the most likely explanations,” they concluded. “However, it is hard to rule out that long periods of near zero policy rates have implied that only low expected inflation is compatible with the current fundamentals of the economy.”

Notes and References

¹ Zervas, Georgios; Proserpio, Davide; and Byers, John W. “The Rise of the Sharing Economy: Estimating the Impact of Airbnb on the Hotel Industry.” Journal of Marketing Research, 2017, Vol. 54, No. 5, pp. 687-705.

² Fujita, Shigeru; and Fujiwara, Ippei. “Aging and Declining Trends in the Real Interest Rate and Inflation: Japanese Experience (PDF).” Unpublished manuscript, August 2015.

³ Alesina, Alberto; and Summers, Lawrence H. “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence.” Journal of Money, Credit and Banking, 1993, Vol. 25, No. 2, pp. 151-62.

⁴ For more on the Fisher relationship, see Williamson, Stephen. “Neo-Fisherism: A Radical Idea, or the Most Obvious Solution to the Low-Inflation Problem?” Regional Economist, 2016, Vol. 24, No. 3, pp. 5-9.

Additional Resources

• Regional Economist: Why Is Inflation So Low?
• On the Economy: How Can Venezuela Address Its Hyperinflation?
• On the Economy: Older Workers Account for All Net Job Growth Since 2000