Inflation, contrary to Milton Friedman, is after all a real and not a monetary phenomenon.
The intersection of the aggregate demand (AD) and aggregate supply (AS) curves determines the price level. Change in the price level or inflation, therefore, is dependent on the shifts in the AD and AS curves. Economic slowdown in China due to its structural transformation from a manufacturing and exports-based economy to a consumption and services-based economy and the slow economic recovery in Europe after the 2007-2008 financial crisis have considerably reduced the pricing power of businesses. With aggregate demand falling globally during the Great Recession due to the financial crisis, the aggregate demand curve has shifted to the left, lowering the price level, causing disinflation. Excess supply of commodities because of competition for market share among commodity suppliers has caused a steep decline in commodity prices worldwide, putting greater downward pressure on the overall price level.
Central banks of the Group of Seven (G7) countries, whose currencies command the most market share in international trade, have lowered interest rates to zero or near-zero level to revive their economies. At the zero bound they also engaged in buying massive quantities of bonds, known as Quantitative Easing (QE), to inject cash into the economy, and in the process grew their balance sheets enormously.
To spur investment and growth central banks not only lowered short-term interest rates but also long term rates by buying long bonds and other long term financial assets on a large scale. Such an increase in money supply should theoretically cause inflation by raising prices because more money chases the same amount of goods and services available in an economy when the cash is not used for real investment. In fact, even though central banks increased the money supply, the money is sitting as excess reserves in the central bank accounts of the banks and is not circulating in the real, non-financial sector of the economy to cause inflation (various financial asset prices could be inflated instead).
The G7 countries are in a ‘liquidity trap’ – the cash is not being used for raising real investment because financial institutions, in a low (zero nominal interest) rate environment, prefer hoarding cash instead of lending out the money for real investment when the aggregate demand is low. The more the money supply at zero or near-zero nominal rate of interest, the more the cash hoarding and inflation in the financial sector leading to bubbles in the financial markets. This is made worse when, for example, the Federal Reserve in the United States is paying interest on excess reserves (IOER) creating an incentive for banks not to lend out the excess reserves.
In the absence of targeted fiscal incentives to raise real investment, the G7 countries are operating well below their potential growth rates causing low inflation. The eurozone and Japan have now opted for negative interest rates to flush the hoarded cash out of the central bank accounts of banks into the real economy to ignite real investment, employment, aggregate demand, growth and hence, inflation. This, however, cannot be done by the central banks alone. Fiscal incentives and perhaps even higher public spending are necessary if – instead of higher public spending from government tax receipts or budget deficits – monetary policy refuses to be even more unconventional by directly lending to targeted industries in the economy to raise real investment, employment, aggregate demand, growth and hence, inflation.