The presentationIn recent months, we have seen a consistent increase in the inflation environment worldwide—and particularly in the US, where inflation in May was 5 percent, a pace we haven’t seen in many years. In Israel, the increase in the inflation rate has been more moderate—actual inflation entered the target range in May, and even more interesting is that inflation expectations, even for a range of 1 year, reached a level of about 2 percent, which is also something we haven’t seen in quite some time. In this lecture, I will try to analyze the expected trends in inflation as we exit the coronavirus crisis and their possible ramifications on monetary policy.
Some background: Before the COVID-19 crisis, we experienced 20 years of the “Age of Disinflation”. It seems like a long time ago, but just before the crisis we were all saying that inflation is very low, and we asked ourselves, what can and should central banks do about that? It happened after a very long process of disinflation—here in Israel we declined from triple-digit inflation in the 1980s and double-digit inflation in the 1990s to low inflation in the 2000s, and since 2014 we found ourselves, most of the time, missing the lower bound of the target range. The low rate of inflation was accompanied by very low volatility in inflation, as well as a decline in volatility of economic growth, which was termed the Great Moderation. Now, in light of recent developments, we have to try to understand what will be more significant in terms of the impact on inflation—the long-term trend of recent decades, or the short-term trend of recent months.
The moderation and stabilization of inflation were not coincidental, and central banks can take credit for part of the achievement—the inflation target regime, which was adopted in many countries, turned out to be a very efficient tool for moderating inflation—and moreover, a very efficient tool for entrenching inflation expectations within the target range. In Israel, for example, despite the inflation rate declining to below the target range for several years, inflation expectations for longer terms remained anchored at the middle of the target—the public and financial markets believed in the intent and the ability of the Bank of Israel to keep inflation within the target range over the long term. This is an important result because long-term expectations impact on the manner in which the various economic entities plan their budgets and price their goods and services looking ahead. The need to stabilize inflation also brought discipline to fiscal policy, which was reflected in the growth in the number of countries that began to act in accordance with clear fiscal rules. Another factor that contributed to moderation of inflation is the growth in the global labor force—from 1990 through 2020 it increased by a billion people. Most of the growth was in East Asia, and in parallel, this additional labor force joined the global economic system and the production chains. For example, China joined the World Trade Organization in 2011. In university, we learned about the Phillips curve, according to which the lower unemployment is, the higher inflation is, and vice versa. In recent years, this connection weakened, as inflation remained low despite unemployment rates that contend to decline, and while we all attempt to understand why the Phillips curve ceased to function at the national level, it may be that we actually have to look for that connection at the global level—the global labor supply increased and that is what helped to keep inflation low. Another notable long-term factor is technological development, which increased labor productivity over time, reduced unit labor cost, and made it possible for us to enjoy a wide range of goods and services at low prices, sometimes even for free.
These trends did not skip over Israel, which also experienced a long period of low levels of inflation. Among the specific factors that led to low levels of inflation in Israel are reforms and important government policy for opening the economy to competition and for reducing the cost of living, the public’s increased awareness of the cost of living, and the appreciation of the shekel. These domestic factors, together with the impact of low inflation worldwide, led to inflation of tradable goods in Israel being very low, at times even negative.
The low inflation, and various factors that led to excess supply of savings over demand for investment, led interest rates stabilizing at around the zero lower bound. Although in Israel, the interest rate increased upon the exit from the financial crisis, and afterwards declined again, and in the US, a moderate interest-rate increase began in 2016, followed by a sharp reduction with the outbreak of the COVID-19 crisis, the overall picture is of a decade of very low interest rates. In the two years before the outbreak of the pandemic, we asked ourselves at the Bank of Israel if the low interest rate would be a problem when the next crisis arrives, in terms of the central bank’s ability to respond to crisis. Of course, there was no way to assess that the crisis would arrive so soon and would be so significant. However, we learned again in this crisis, as in the previous crisis, that central banks have a wide range of tools even when the interest rate reaches a level below which continued reductions are not wanted. Thus, when the crisis erupted, the interest rate already being low—a result of the low inflation before the crisis—was not a marked limitation on operating policy tools for dealing with the crisis. The various monetary policy tools succeeded in providing liquidity, stabilizing markets, and in reducing financing costs for households, businesses, and the government, (despite the increase in the deficit and in the debt to GDP ratio).
The people setting monetary policy also had some luck during the COVID-19 crisis, as the policy tools required to achieve the various goals for dealing with the crisis were all aimed in the same direction: the low inflation, the adverse impact on economic activity, and the need to bring the liquidity back to the financial markets—essentially they all called for accommodative monetary policy. In the exit from the crisis, this will not necessarily be the case, and the challenge is liable to be more complicated. While unemployment remains very high, inflation is beginning to increase (a bit less in Israel, and a bit more in the US), and the “heating up” in some financial markets is liable to serve as a warning light for the policy makers who are responsible for financial stability.
Is the increase in inflation transitory? Upon the exit from the crisis, we see growth in demand and at same time a negative impact on production chains and supply. So we can ask—how long will the effect of these factors last? And in contrast, will the long term factors that led to the long-term process of disinflation continue to act and lead to inflation remaining low?
In my assessment, the long-term factors are expected to continue to have a significant impact on inflation. Although the growth in the global labor force has slowed, there are still hundreds of millions of people in developing economies that are waiting for their opportunity to join the labor force and the global production chain. So long as there isn’t a retreat from globalization, this factor will continue to support the low price levels in advanced economies. The technological factors that I mentioned have only strengthened since the coronavirus crisis, and are expected to continue to support growth of productivity. Central banks, for their part, are still committed to their inflation targets, and even if some are rethinking the inflation target, a retreat from that commitment is not expected. In the short term, they will continue to conduct very accommodative policy, in view of the unemployment rates, which are still very high despite the exit from the crisis.
How will all this impact on monetary policy in Israel? Although our inflation rate increased, it remains low, and is very far from what we see in the US. We can see that inflation for us is more in line—in terms of both volatility and level—with inflation in Europe than with inflation in the US. Thus, as long as there isn’t a marked increase in inflation in Europe, it is apparently possible to be less concerned with the increase in inflation in the US. In addition, the prolonged appreciation of the shekel moderated the increase in prices of tradable goods in recent years. Thus, given this range of factors, it appears that we have enough reasons to be patient with our monetary policy, and to allow it to be accommodative enough to continue to support the economy’s recovery from the crisis.
The main challenge for monetary policy derives, in my opinion, from the risk to financial stability. Global monetary policy that is very accommodative for an extended period of time is liable to lead to increased leverage and to taking of excess risks. There is considerable evidence of this worldwide—the rush to crypto currencies, events like the volatility in GameStop shares, or the bankruptcies of private investment funds to which large banks had considerable exposure. Central banks will have to follow events carefully and to verify that risks that will be difficult to control are not developing, and to develop tools that will enable them to moderate the risks deriving from overleverage and increased appetite for risk.