“The most important lesson from the 1930s, as well as from the modern-day Japanese experience, is that monetary policy provides no answer for a chronic deficiency of aggregate demand. Addressing it is a task primarily for fiscal authorities. The idea that central banks should consider making a new promise to raise their inflation targets is hardly credible.” (Stephen S. Roach, Project Syndicate, Another Lesson from Japan, June 26, 2017)

Many years ago, John Maynard Keynes concluded that when an economy is in a deflationary phase, monetary policy becomes virtually incapable of stimulating an economy out of a low growth trap.

This scenario has been playing itself out for a long while in Japan which has continuously faced deflationary pressures, and now to a lesser extent, the same phenomenon is at work on the U.S. economy.

As Stephen Roach indicates, despite the Fed’s best efforts to stimulate the economy and raise the rate of inflation, the American inflation rate seems stuck at an unusually low rate. U.S. monetary policy and quantitative easing have probably already achieved their best outcomes, and now seem to be operating in a diminishing return environment.

This explanation is broadly accepted by a number of international organizations that also urge a heavier reliance on fiscal policy to escalate wage and price inflation. For example, even though in its latest forecast the International Monetary Fund projects a modest improvement in global economic growth, inflation in the advanced economies is expected to average less than 2% in 2017-2018.

The unusually weak inflation rate in the U.S. this year is particularly surprising. The nearly fully employed U.S. economy (4.3% unemployment in May) has not generated higher inflation because the Phillips curve relationship seems to have broken down. The Phillips curve relationship is based on an expected inverse relationship between low unemployment and higher wage and price inflation.

The unbundling of the linkage between low unemployment and higher inflation seems related to the fact that globally there is a huge excess of supply of goods and services relative to demand.

As Stephen Roach points out, because of the hangovers from balance-sheet recessions in Japan and the U.S., fear-driven precautionary saving in China, weak consumption in productivity-constrained Europe, the demand side of most major economies remains severely impaired. Juxtaposed against a backdrop of ever-expanding global supply, the resulting imbalance is inherently deflationary.

With interest rates so low and effectively close to zero in the euro area and Japan, monetary policy is simply unable to stimulate the chronically deficient demand side of their economies. 

As the following three charts illustrate, price inflation continues to be extremely depressed in the U.S., Japan, and the Euro Area. These three advanced countries account for a huge proportion of the world economy.

Weak Price Inflation In The U.S., Japan And The Euro Area

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