Combating Persistent Disinflation: A Challenge for Many Central Banks

IMF News, September 27, 2016

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The study, published in the IMF’s October 2016 World Economic Outlook, finds that low and falling inflation in the aftermath of the Great Recession is a broad-based phenomenon across countries, measures, and sectors.
By 2015, inflation rates were below medium-term expectations in more than 85 percent of a broad sample of more than 120 economies—20 percent of which were actually experiencing outright deflation.
Core inflation, which excludes food and oil prices, has also slipped below central banks’ inflation targets in most advanced economies and in many emerging market economies.
The decline in inflation has been more pronounced for tradable consumer goods (such as cars and TVs) and for manufacturing producer prices than for services (communications and financial services).

Persistent economic slack at home—driven by weak demand and growth—has been a main contributor.
Falling commodity prices, including the sharp drop in oil prices since 2014, have contributed to lower inflation.
Subdued import prices have played a key role; industrial slack in large exporters has depressed global prices of tradable goods.
Investment in tradable goods sectors in some large economies, notably China, grew strongly after the global financial crisis on the back of projections for global and domestic demand that ex post fell short of expectations, creating excess capacity and downward pressure on international prices of tradable goods.

Most available measures of inflation expectations have not declined substantially so far.
However, the study finds that the response of inflation expectations to unexpected changes in inflation—the sensitivity that indicates how well “anchored” expectations are—has increased in countries whose interest rates are close to or below zero.
This increase in sensitivity implies that inflation expectations are becoming de-anchored from central banks’ targets in those countries, suggesting the perceived ability of monetary policy to combat persistent disinflation may be diminishing.
While the economic magnitude of this “de-anchoring” is still relatively small, it raises concern because repeated disinflation could lead firms and households to revise down beliefs about future prices, postponing spending and investment and exacerbating deflationary pressures.

Short-lived disinflation driven by supply shocks (for example, energy price declines) or productivity gains can be benign or beneficial.
Persistent disinflation risks triggering costly deflationary cycles—where weak demand and deflation reinforce each other, increasing debt burdens and hindering economic activity and job creation (as illustrated by Japan’s experience).
The study assesses that the risk that current widespread disinflation would evolve into damaging deflation-trap situations is still small, but reversing deflationary dynamics once they set in is very difficult, so complacency is not an option.

Bold policy actions are needed to avoid chronically undershooting inflation targets and eroding the credibility of monetary policy, especially in advanced economies.
A comprehensive and coordinated approach across all available policy levers is recommended given limited policy space in many economies. This broadly involves:
- Complementing continued monetary accommodation with growth-friendly fiscal policies.
- Implementing income policies in countries where wages are stagnant.
- Pursuing demand-supporting structural reforms.
- Addressing crisis legacies such as debt overhangs and large non-performing bank loans.
The goal is to boost demand and firm up inflation expectations to prevent a downward drift that could cut into economic activity and jobs.

IMF Research Department — Samya Beidas‑Strom, Davide Furceri, and Bertrand Gruss; September 27, 2016.