The increase in long-term interest rates observed during spring is normal. It results from both the expectation of high government debts, and the fact that we are pulling out of a period of extreme risk aversion and signs of a cyclical upswing have appeared. At this level, these rates do not point to inflation spinning out of control. Medium-term inflation expectations, e.g. as taken from the University of Michigan survey, remain firmly anchored in line with the Fed’s objective. Concerns that inflation may make a comeback, in the coming few years, seem to be highly exaggerated. First of all, productive capacity is massively under-utilised virtually everywhere(1). Global growth, according to the IMF, should stand at -1.3% in 2009 after expanding for several years at a pace of nearly 6%. Accordingly, the world’s GDP this year will be about USD 4,000 bn lower than would have been the case if the growth rate of the last few years had been maintained. Growth expected next year, still below potential, will lift this amount further. Fiscal stimulus packages that, most of the time, cover two or sometimes three years, hardly total USD 3,000 bn. They do not seem to have any inflationary potential for the time being. Moreover, foreseeable growth in the next few years is unlikely to result in strains on demand. Households are now in a phase where they are seeking to restore their financial situation. In other words, a surge in borrowing likely to lead to growth in household demand outpacing growth in incomes does not seem to be on the cards, all the more so as household incomes are affected by the deterioration in the labour market. Therefore, the extent to which productive capacity is under-utilised, combined with the tightening in credit conditions, apparently rules out a significant upturn in investment. Lastly, the positive effect of fiscal stimulus packages will not be repeated. On the contrary, the anticipation that measures will be taken to ensure that the public debt levels off, with tax hikes the most likely solution, also means that a sharp recovery in demand is unlikely. In fact, growth will probably not be robust enough to lead by itself to the public debt flattening out, while cuts in expenditure are hard to implement because several budget items cannot be reduced (wages, expenditure on pensions, health, and so forth). As a result, there are grounds to fear that debts will be monetised… What is to be thought about such an outcome? In previous cycles, the recovery led to growth being higher than its potential because it was fuelled by a significant increase in lending. In this respect, the forthcoming recovery appears to be different. Employment, a lagging indicator of the cycle, will further contract and joblessness will continue to rise, while the under-utilisation of productive capacity will persist. A significant slowdown in wage growth has already showed up. A rebound in productivity gains has begun in the US, it will materialize after some delay in Euroland. Together with the moderation in compensation, that will result in a downturn in unit labor costs, the main element behind underlying inflation.
This hardly suggests that wage costs will gather momentum nor that companies will rapidly recover pricing power, all the more so as we are talking about worldwide developments. In other words, nothing in the real economy is likely to generate inflationary pressures. Monetary creation by central banks has not led to an acceleration in broad monetary aggregates; in fact, the opposite is occurring due to the slowdown in credit1. Some fear the monetisation of the deficit by the central banks, others consider that inflation is the only way for the economic to get out of the woods by lowering the real debt. Some central banks have bought Treasury bonds, e.g. the Fed and the Bank of England, in order to inject liquidity and weigh on long-term interest rates, but not to finance deficits directly. Furthermore, central bank independences is asserted in their statues. Price stability is one of their objectives. One fails to see how they could conduct a policy likely to result in a wave of inflation — the fact that they may want to avoid deflation, ensure expectations are anchored in positive territory and lower the inflation rate to a level close to their target is another matter. But such a policy would destroy for a long time the gains painfully achieved thanks to disinflation in the 1980s. It is hard to see how a government could ask a central bank to do this. The central banks have become very transparent. In particular, they regularly publish their inflation projections. It is difficult to imagine them showing inflation to deviate persistently from the stated targets. Furthermore, it is not at all obvious that a decline in the debt ratio, resulting from an acceleration in inflation, is a realistic option in an open economy characterised by a highly internationalised bond market: nearly all sovereign bond issues are subscribed to by institutional investors who are very sensitive to the risk of inflation, and for instance half of outstanding government bonds are held by non-residents in the United States as well as in France. In such a context, the inflation risk would lead to a more substantial increase in interest rates than the additional inflation, because it would include an inflation risk premium. Hoping that a decline in the debt ratio would be achieved thanks to an upturn in inflation under these conditions, may well turn out to be misguided. Moreover, governments have issued significant amounts of inflation-indexed bonds. Lastly, pension funds have to a large extent invested their assets in government securities. In a nutshell, given population ageing and the issue of how pensions are to be funded, monetary erosion could hardly be a very popular solution. It would be a paradox if governments were to end prematurely their policy aimed at boosting the economy because of unfounded concerns. The huge increase in the monetary base in Japan certainly did not result in inflation. Conversely, the excessively rapid tightening of fiscal policy in 1996 drove the Japanese economy back into recession. Disappointments are to be expected in the medium term since potential growth is to moderate Suppose demand could be accelerated thanks to an inflationary monetary policy, something that has to be proved, would economic activity be supported? The answer is not that obvious. First, because of the reaction in rates as already underlined. Second, because of the constraints that would be met on the supply side. In fact, potential growth, as it is linked to structural productivity gains and changes in the working-age population, is set to decline. It will likely fail to exceed 2.25% in the United States and will come in between 1% and 1.25% in the eurozone. For, because of population ageing, the working-age population, which was increasing 1.3% per year in the United States in the mid-1990s, will flatten out by the late 2010s. In the eurozone, after increasing 0.3% in the early 2000s, it will sink to zero next year and drop 0.5% per year in the next ten years. Furthermore, in the eurozone, the NAIRU, i.e. the unemployment rate compatible with price stability, is expected to jump from 8.5% before the crisis broke out to 10% next year, and this means it will be more difficult to mobilise the labour force. At the same time, growth in productive capacity will be curbed by the decline in investment. According to European Commission data, the investment-to-GDP ratio will drop from 22.7% in 2007 to 19.1% next year. Lastly, a noteworthy point is that financial crises themselves have negative effects on the productive potential via their impact on risk premia and the tightening in credit conditions. David Furceri and Annabelle Mourougane(2) for instance have shown, by drawing on a sample of 30 countries studied during the period 1960-2007, that four years after a crisis breaks out, potential GDP on average is lowered by circa 2% and by 4% in the wake of the most severe crises, e.g. Spain in 1977, Norway in 1987, Finland and Sweden in 1991 and Japan in 1992. 1) See Conjoncture June 2009 « A historical recession (Part 2 : The Green shoots) »
2) The Effect of Financial Crises on Potential Output : New Empirical Evidence from OECD Countries” OECD Working Paper 699 – May 2009