NN IP: Three theories of inflation

The quantity theory of money

The inflation outlook will be an important driving factor for financial markets this year. This week we will therefore discuss three theoretical angles. We start with the most well-known one, i.e. the quantity theory of money, which holds that the supply of money (M)  multiplied by the number of times it changes hands (V for velocity) in a certain period must by definition be equal the level of nominal GDP. This equation is the theoretical basis for Milton Friedman’s famous statement that “inflation is always and everywhere a monetary phenomenon”. It is important to bear in mind that the quantity theory is true by definition. As a result, it says nothing about the underlying processes, which ensures that it holds. These processes do involve changes in asset prices, real activity and inflation, so in a sense they constitute the really interesting part. What’s more, whereas money was a clearly defined concept in earlier days when we still used gold or silver coins or when all countries were on the gold standard, nowadays it is a pretty nebulous concept. When it comes to liquidity properties, traditional forms of money (currency and current account deposits) face stiff competition from other assets (e.g. short-term safe Treasuries). As a result, we believe the quantity theory has limited value in understanding inflation.

The Phillips curve

The second theory, the Phillips curve, is a cornerstone of much of modern macroeconomics and features prominently in the models central banks use to forecast inflation. One of the most important inflation drivers in this theory are expectations of future inflation. If unions believe inflation next year will be 2% they will build this into their wage demands, if producers believe their cost base will rise by 2% they will build this into price setting, etc. In this sense these expectations help to create their own reality. In theory, these expectations should be rational which loosely means that economic agents use all available information, including their knowledge of the structure of the economy and the central bank’s decision making process. As a result, they will not make any systematic mistakes in forecasting inflation. The importance of expectations puts a big premium on central bank credibility. If the central bank can convince the public that it will ensure that inflation will be equal to the target on average in the long run, then the public will act accordingly which makes it easier for the central bank to achieve its target. If the inflation target is not credible, agents will resort to using some other rule of thumb to predict future inflation. In this respect, they tend to use inflation rates of the recent past which is the reason why unanchored inflation expectations tend to drift away further in the direction in which they became detached from the target in the first place. 

More generally, people do not have rational expectations in practice but probably use rules of thumb all the time. If actual inflation has followed a relatively stable and mean-reverting process, the majority of agents could well at least implicitly behave as if this process will be continued into the future. Such rules of thumb could easily give rise to the possibility of regime shits in inflation. In particular, if inflation deviates substantially and for a long period of time from the stable process it had before, then agents could start to use a different rule of thumb. This would explain why sometimes the rate of inflation can change dramatically in a short period as it did in Weimar Germany in the 1920’s, which switched from mild deflation to hyperinflation in less than a year. It would also explain why it is harder for Japan to escape the lowflation trap than many had anticipated. Japanese agents probably do not continuously update their expectations but stick to the rule of thumb that inflation is virtually absent until they see convincing proof that this is not the case.

The output gap

The second important driver of inflation is the output gap, which is loosely defined as the difference between supply and demand in the overall economy. Such a difference can persist for a long time because in many markets prices do not always adjust instantaneously. Because many mainstream economic theories assume that the supply side is fixed by the quantity and quality of the factors of production, the demand side tends to act as the biggest driver of changes in the output gap. The New Keynesian version of the Phillips curve is the one used in most models used by central banks, which is why is it useful to explain the basic theory behind it. An important underlying assumption is that all firms operate in markets of monopolistic competition, for instance because each firm produces a different variety of a product. This gives each firm some degree of pricing power and standard economic theory then yields the result that prices are set as a fixed mark-up over marginal cost. The latter are to a considerable extent driven by the degree of slack in the labour market. If the unemployment rate falls below its equilibrium level, wage growth will start to exceed productivity growth which causes an increase in marginal costs driven by rising unit labour costs. Here, the equilibrium unemployment rate, or NAIRU, is defined as the unemployment rate which obtains in the model when all prices and wages are flexible, in which case the economy attains a unique long-run equilibrium. 

In real life, potential output and the NAIRU are not carved in stone in the way New Keynesian economics assumes. In fact, other models do allow for variations, driven by the interplay between consumer preferences concerning consumption and saving, labour and leisure, as well as constraints presented by dynamics of demographics and technological change. On top of this, the economy may well be subject to path dependency. Persistent demand shocks can have long lasting effects on the supply side. For instance, a prolonged, deep slump will cause workers to lose skills and push investment spending on a lower path with detrimental consequences for the level and growth rate of potential output. Of course, this can go into reverse as well: Strong demand growth could push supply onto a permanently higher path. All this makes the concept of the output gap a bit fuzzy in practice.

Heterodox explanations for inflation

Non-mainstream economic theories can provide some useful insights on the two basic drivers of the Phillips curve. The market economy is seen as a highly productive, but also unstable system which is driven by conflicts between various actors. One of the prime reasons for instability is the central role of expectations, or animal spirits, which are not put in the cage of rationality or become subservient to the fundamentals of technology and preferences. In fact, one could say that animal spirits are an important fundamental in this theory which is a central driver for investment spending. An increase in investment on the back of a rise in animal spirits requires firms to borrow funds and thus leads to an endogenous increase in credit, which ends up as deposits for other businesses (which sell the investment goods) and consumers (because of the increase in labour demand that comes with increased investment). These actors in turn increase their spending as well etc. Note how in this process the increase in investment spending automatically triggers a matching increase in saving, because actors save a portion of their rising incomes. If the optimistic expectations are validated, the expansion can continue. However, the fickleness of expectations is a central feature of heterodox economics and a sudden jump towards more pessimistic expectations can cause a severe downturn which is enhanced by balance sheet problems for the debtors in the economy.

A key question is how to tame these dynamics. In general, the answer is sought in the importance of institutions which can be defined as the rules of the game. These can be formal but also informal and their main task is to stabilise expectations at a level consistent with a decent growth path and thus help to reduce some of the uncertainty faced by economic agents. If you think all of this is a bit crazy then consider this: If back in 2011 we had had appropriate institutions in the Eurozone, peripheral default expectations would not have embarked on an explosive self-fulfilling path and we might well have had an equilibrium with higher yields and lower unemployment today!

In this model, inflation is seen as the result of a distributional conflict between wage earners and entrepreneurs. If wage earners attempt to grab a bigger share of the pie, businesses will try to compensate for the implied reduction in profit margins by raising prices. This in turn induces wage earners to bargain for higher nominal wages etc. This distributional conflict becomes more severe if there are factors which reduce the size of the pie, such as an increase in commodity prices, exchange rate depreciation or a negative productivity shock. This is actually an intuitively appealing explanation for the Great Inflation of the 1970’s. This inflation process is essentially also about expectations (about the share of the pie you can ensure for yourself) and appropriate institutional arrangements can tame these expectations and guide them towards a more benign outcome. The rise of central bank independence and inflation targeting can be seen as such institutions. A credible inflation target will act as an incentive to not try and grab a much bigger share of the pie, because in doing so you may price yourself out of the market.

The most important inflation lessons to take away from these theories are their emphasis on the role of institutions in the wage bargaining process and how the latter is part of a distributional conflict. This wage bargaining process is much more realistic than the assumption that real wages are determined in the labour market, in the same way that the oil price is determined by the demand and supply for oil. Labour is a much differentiated commodity. There is not one big labour market but many small ones which of course are connected. As for the distributional conflict, one can say that labour clearly lost a lot over the past 20 years. In the US the labour share income is still at a post-WWII low, even with an unemployment rate of 4.1%. This is a reason to believe that a sharp acceleration in wage inflation that will prove to be inflationary is not likely in the near future.

Emerging markets: credit rating action

In the past week, there were three significant EM credit rating changes. First was Moody’s upgrade of Greece from Caa2 to B3 with a positive outlook. In the previous weeks, S&P and Fitch had also upgraded the country. The B3 from Moody’s is still six notches below investment grade, so Greece still has a long way to go. The upgrade was based on expectations that Greece will finish its third adjustment programme successfully and that it will be able to finance itself in the market again. Moody’s also mentioned the creditors’ strong commitment to providing further debt relief. More rating upgrades can be expected if the implemented reforms yield better results than projected, pushing sustainable growth higher and reducing public debt ratios further.

Secondly, Fitch downgraded Brazil from BB to BB-, three notches below investment grade. The reason was the large fiscal deficit of about 8% of GDP and the government’s failure to get reforms through Congress that would have reduced social-security and pension spending. It became clear last week that the Temer administration will not get the crucial pension reforms passed, which it had been working on for the last year and a half. Elections are in October, so even if a reformist candidate wins, reforms will not be ready for at least a year or so. So the unsustainable fiscal situation continues. With global interest rates rising and Brazilian inflation likely to move higher in the coming quarters, this remains one of the EM risks worth monitoring.

Finally, S&P upgraded Russia for the first time in 12 years, restoring the country’s investment grade rating with a move from BB+ to BBB-. Key reasons were the inflexible exchange rate, which has helped and should continue to help the country absorb shocks from international sanctions and commodity prices. S&P also mentioned the prudent fiscal policy framework and the encouraging pick-up in credit to the private sector.