A Decade of Lost Inflation: What Happened?
In the wake of the 2008 Global Financial Crisis, the U.S. government was pulling all levers to try and stabilize the economy and get growth back on track. In addition to unprecedented bailout programs like TARP and liquidity-boosting schemes like QE1 and QE2, the Federal Reserve also effectively lowered interest rates to zero. In all, between 2008 and 2015, the Fed’s balance sheet soared from $900 billion to $4.5 trillion.
As the U.S. economy started to recover and grow, a new consensus formed about what was likely to happen next: runaway inflation. Even with the benefit of hindsight, calling for higher levels of inflation seemed at the time like a very logical conclusion to draw. With the Fed essentially eliminating the cost of borrowing and injecting trillions of dollars into U.S. companies and the financial system, surely we’d see a surge in inflation to be reckoned with down the road…right?
Yet here we are a decade later, with no signs of runaway inflation. There has been no inflation ‘reckoning,’ no systematic monetary policy tightening to try and stave off higher prices. In the months and years just after the financial crisis, consensus had largely been that the fed funds rate would be north of 4% by 2020. But with just a handful of days left in the year, the fed funds rate remains in a range of 1.5% to 1.75%, with the economy trudging along with below-target inflation and slower-than-average economic, wage, and productivity growth (but better-than-expected employment).2
Even as the Fed has Kept Interest Rates “Lower for Longer,” Inflation Remains in Check
Source: Federal Reserve Bank of St. Louis4
So, What Happened? Why Did Inflation Never Really Take Hold?
I’m not sure we’re at a point in history yet where it’s possible to look back at this decade and understand exactly why inflation remained so subdued, for so long. But there are a few working theories I’ll share with readers.
First - the return of the savers. In the wake of a financial crisis – particularly one that profoundly affected nearly every American – we tend to see households, businesses, and banks de-risk and take steps to improve balance sheets. Regulation forced banks to make such changes, and households followed suit and paid down debt in the ensuing years. These actions generally mean less borrowing, investing, and risk-taking, which keeps a lid on growth, inflation, and interest rates. As you can see from the chart below, household debt to GDP fell significantly in the years following the recession.
Household Debt-to-GDP Ratio in the U.S., 2005 - Current
Source: Federal Reserve Bank of St. Louis5
A second possible cause for weak inflation is technology, which has actually been a deflationary force since the 1990’s, in my view. I also believe in the possibility that technology’s cost-reduction results in a multiplier effect, which results in various deflationary linkages throughout the economy.
There are myriad ways to think about how technology has reduced the cost of goods and the cost of doing business. Think about household goods and retail. The massive shift to buying goods via e-commerce (online shopping, Amazon) versus a trip to a brick-and-mortar store may increase the cost of physical delivery, but it reduces or eliminates cost of real estate, utilities, requires few workers, lowers inventory carrying costs, and uses data to target consumers with precision ads – which are far more effective than traditional marketing methods. In all, technology has driven efficiency, which has kept a lid on costs and prices.
Finally, a third possible explanation for subdued inflation over the last ten years is spare capacity in the U.S. economy. The ‘Great Recession’ led to such a dramatic decline in output, job losses, and wealth destruction that it created a substantial amount of spare capacity in the economy that we’re only now starting to reach. It would make sense, then, that price pressures would remain tepid so long as that spare capacity existed.