Why is inflation below expectations? And why does low inflation matter?


  • The Lowdown on Low Inflation

Sometimes, things in life exceed your wildest dreams. And sometimes, you are reminded that you should be careful what you wish for.

My dreams were formed in the 1970s, a decade many would like to forget. It lacked the peace and prosperity of the 1950s, and couldn’t match the passion and possibility of the 1960s. The 1970s were bad: crime was high, cars were unreliable, clothing styles were overly bright and film themes were overly dark. And undisputedly, the world’s economy was very dark.

Oil shocks in 1973 and 1979 shook the foundations of Western economies. Heavy industries were hollowed out, putting millions out of work. Inflation raged, partly as a result of poor monetary policy. Efforts to tame runaway prices ranged from the counterproductive (wage and price controls) to the comical (President Ford’s “Whip Inflation Now” button). Nominal interest rates skyrocketed, choking off housing and business investment.

During this interval, economists developed a “misery index” that combined the unemployment rate and the inflation rate. It peaked at over 25% in a number of countries. I was one of the unemployed, and one of the ones rapidly losing purchasing power. I was hoping, somehow, that we could tame inflation and interest rates.

Today the misery index is less than 6% in many major countries. Interest rates are negative in a number of markets and barely positive in others. There is still concern over inflation, but today, we are worried it is too low.

Orange lettering describing economics

A number of elements have combined to produce this outcome. This essay will attempt to enumerate the most major of them, and assess how they might progress going forward. This evolution will be critical to economic performance in the generation to come.

Winning Hearts and Minds

While we can try to model the economy, underneath all of that activity are human beings. We are not always rational actors; psychology can, at times, play an outsized role in our decision-making. This is an especially important foundation of inflation: if we expect prices to rise rapidly, we increase our wage demands in compensation. The resulting wage-price spiral can be difficult to arrest, given our vulnerability to confirmation bias and other behavioral imperfections.

Central bankers were overly indulgent of inflation in the 1970s, preferring to keep credit spigots open. Finally, at the end of the decade, Paul Volcker was appointed chairman of the Federal Reserve. Drawing on work from The Chicago School, Volcker set his sights on controlling the supply of money.

It was painful; the Fed’s credit restrictions pushed the U.S. economy into recession. But Volcker’s persistence in the face of heavy criticism finally reversed inflation expectations. At the beginning of the 1980s, respondents to the University of Michigan consumer sentiment survey were calling for inflation of more than 10%; at the end of the decade, that number had fallen to less than 4%.

Chart of inflation