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Subdued US Inflation: The Lingering Legacy of Numerous Forces

The large increase in monetary accommodation engineered by the Fed since the Great Recession has not produced significant inflation, contrary to the predictions of monetarism. Money velocity collapsed, indicating the arrival of a major liquidity trap whereby the private sector preferred to hold cash due to the arrival of abnormally low bond yields.

Falling money velocity in a liquidity trap will typically be associated with declining inflationary expectations. Engineering rising inflationary expectations is more difficult once an economy has entered a liquidity trap, and this helps to explain the persistence of low US inflation.

Technology innovation, via the rise of the internet, has also helped to contribute to low inflation by reducing the effective search cost for consumers of obtaining price information to zero. Furthermore, supply chains have also been squeezed due to the internet removing unnecessary middlemen between producers and consumers.

Globalisation is still imparting disinflationary forces, despite President Trump’s wish to encourage greater import substitution in the US. Meanwhile, world trade is continuing to contribute to the flat US Philips Curve that has confounded the Fed.

The perception of faster growth opportunities in emerging markets due to better demographic backdrops has helped to persuade US companies to temper domestic capital formation since 2009. Meanwhile, ageing US demographics since 2010 has reduced inflationary pressures, partly due to older households being less susceptible to conspicuous consumption, along with a more subdued recovery in net worth compared with younger groups.

Fed Chair Yellen’s conviction that low inflation is temporary is reflected in the Federal Open Market Committee’s (FOMC) baseline policy outlook for 2018, involving three increases in the federal funds rate. The future movements of two key housing components within the consumer price index will probably verify whether Chair Yellen is correct in her view about transiency.