Opinion | The world could be staring at a long era of deflation
4 min read 10 Sep 2019, 11:15 PM ISTThe inversion of the US bond yield curve may be indicative of rapid innovation crushing prices for years on end
PremiumThere are three games of chicken currently in play in the US. The first concerns its ongoing trade-cum-currency war with China. For political reasons, this is likely to last for months, unless a solution is reached in the form of a trade deal this October. The second is associated with US President Donald Trump’s constant dissatisfaction with the US Federal Reserve on the need to cut real interest rates more aggressively, though a rate cut happened last quarter and another seems in sight. The third, which seems more perplexing, is the Fed’s internal conflict with firms within the US and its puzzlement over how measures of monetary policy, including rate cuts, are having minimal effect in increasing real productivity growth in that country.
On a closer look, it is critical to see the second issue as entwined with the third, to examine whether rate cuts on their own can actually help improve US productivity.
Moreover, one key aspect that has been bothering most analysts even at the Fed, and now most investors, is the inversion of the bond yield curve, which indicates that a US recession is on the horizon. Why is this marker critical? In normal circumstances, a 40-year mortgage would carry a higher rate than a 20-year mortgage, which is also true of investments in government bonds; the longer the term, the higher the yield (of interest as a percentage of its market price) gained by the bond-holder. An inversion implies a reversal of this: that is, yields on short-term debt exceed those on long-term debt. For example, if someone buys a one-month US government bond, s/he may get annual interest of 2% on it, but a five-year bond might yield less than 1.5% as interest.
If investors doubt the ability of an economy to grow consistently and thus do not demand or receive a higher return on their investments—say, in the bond market—over the long term, there is a serious problem.
What can the Fed do? If one looks closely, short-term interest rates in the US have stayed quite low since the financial crisis of 2007-08. When the Fed dropped rates to near-zero right after the crisis, the expectation was that over time the reduced cost of borrowing would significantly increase economic productivity of US resources such as labour, land and capital, and, as a result, a rebound would give way to “normal" rates. This didn’t happen. In fact, bond yield rate came down to below 1.5%.
What does this mean? For one, it means that existing predictive models and monetary policy tool kits are turning increasingly ineffective in either understanding or addressing the actual reasons for the slowing down of productivity growth.
Cases from Germany and Japan reflect how the simultaneous reduction of interest rates has hardly helped their economies emerge from their productivity slowdown trend.
In my view, perhaps most policymakers are grossly underestimating the effect that technology has had over the last decade or so in suppressing prices around the world, even explaining why real wages for middle- or lower middle-income workers in the US and other countries have almost flattened, despite overall output growth seasonally going up.
To understand this, consider the trends seen in existing measures of inflation: A deflationary phase is evident across emerging and developed economies. A wide band of services and goods are becoming cheaper.
If someone bought a product at $50 in 2017 and then purchased the same product at $40 in 2019, he has got what he needed but at a price that is $10 less than before. From a consumer’s perspective, this is great. However, such price declines add up across an economy, and the nominal value of gross domestic product goes down because of this, thereby affecting various other prices, such as wages.
This phenomenon seems to be part of a global trend, especially in countries where the substitution of labour by capital has taken place at a much faster rate. While this has been argued by the analysis of several recent studies, unfortunately, the discussion has not been at the forefront of policy action or a part of response mechanisms.
The deflatory effect on prices induced by a tech-fuelled model of growth is not a 21st century phenomenon either. The economic history of the 19th century’s Industrial Revolution—when rates of technological innovation remained quite high, saw deflationary effects on a variety of goods, which became available at much lower prices.
The Industrial Revolution mechanised transport and mobility, and their reduced costs let goods be retailed more cheaply. Information and communication technology has done the same, and Artificial Intelligence could also have such an impact.
The broader point is that the trend visible in the inversion of the US bond yield curve may not only signify an economic recession in the near future, but also be a result of rapid technological innovation through its effect on prices.
It is entirely plausible that we are now entering an era of low economic growth and a higher rate of deflation being the norm, especially within spaces where capital is very cheap and interest rates extremely low (or even zero), with the digital economy offering services and goods that get more accessible and cheaper by the day. The tool kits of central banks may increasingly become insufficient to address challenges emerging from this in the context of concerns over labour productivity, wage growth and the social markers of upward mobility.
Deepanshu Mohan is associate professor of economics at O.P Jindal Global University
