Is Inflation really Low?

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All-items (red) and core inflation (blue) rate in the United States (from tradingfloor.com)

The real interest rate on safe assets drives the returns on investments in all other asset classes. The current low inflation rate, that together with the nominal interest rate determines the real rate,  has been forcing central banks worldwide to keep interest rates at rock bottom levels. Inflation is not cooperating with central bankers, who are desperately trying to reach the equilibrium real interest rate below zero.

Generally central banks face a lower bound at zero in setting nominal interest rates, the rest of the job is done by inflation. Going below zero means entering a new phase of capitalism where you make no money by lending (hey, I am talking about nominal rates, real ones have been negative many times before). A new world where credit institutions have squeezed margins (they will lend more, theory suggests) and savers seek the riskiest investments to have the hope of building for their retirement.

The graph above clearly shows that the current disinflationary environment appears so because of the fall of commodity prices. If we exclude food and energy goods from the calculation of the price index (the core rate of inflation), the situation looks very different. Commodity prices drop because of past over-investment and strong dollar and interest rates are affected through the inflation rate. Even if low commodity prices were to give a boost to global demand, it is unlikely that this effect alone would create inflationary pressures – just draw the classic supply and demand graph.

Moving towards an equilibrium does not mean that we will move back to the old one right afterwards. Even if central banks manage to reach the much wanted “equilibrium interest rate”, we are going to see an improvement in the general economic conditions, on employment and income, but we might get stuck there until something else radically changes. Commodity prices will rise only if miners and oil producers take radical action in lowering supply, that is not to be taken for granted (for instance, have a look here).

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