The 'Puzzle' of Vanishing Inflation

Low and unresponsive inflation has been termed a “puzzle.”. The paper combines a monetary model and a growth model to explain low inflation and project its continued decline.

The monetary model forecast in 2016 central banks would fail to reach 2% targets, which has been true. The model explains inflation as changes of the unit value of a currency, a function of long lags of monetary aggregates. The model provides a highly significant statistical explanation for virtually all variability of forward long-term inflation and corresponds closely to inflation expectations measures. Its U.S. inflation forecasts are comparable to recognized leaders in accuracy with potential international applicability as well. The responsiveness of inflation to monetary stimulus is increasingly inelastic at a geometric rate, explaining central banks’ difficulty attaining targets.

While the monetary model explains virtually all variability of long-term inflation, an element of the level of inflation is explained by non-monetary factors, population growth and Hotelling interest rate effects. A Hotelling interest rate effect is found in general inflation from production factors such as labor in addition to commodities, explaining why previous Hotelling commodity tests were generally unsuccessful. A growth model finds natural interest, total factor productivity, and population growth converge and all are related to real growth. Each of these factors has been in fifty year declines in advanced economies, with a consequent reduction of inflation.

Between the decline of real factors affecting inflation and its inelasticity to monetary stimulus, it is far more likely major central banks will be staving off zero inflation or deflation than that they will realize 2% targets.