Inflation: still "a monetary phenomenon"?

Milton Friedman's famous dictum that "inflation is always and everywhere a monetary phenomenon" is looking badly shopworn these days.  When central banks announced their intention of combatting the financial crisis through record-low interest rates and quantitative easing, monetarists were quick to warn that hyperinflation was surely just around the corner.  Even those economists who applauded the unconventional stimulus were concerned about what might happen if "normal" monetary conditions were not restored fairly quickly.  Yet here we are, more than half a decade on, with interest rates still locked at record lows and massive amounts of monetary stimulus still sloshing around in the financial system -- and deflation is still a more pressing fear than inflation.  Were the Friedmanites wrong?

It's a simple question, but not one that has a black-and-white answer.  When most people think about inflation, they have in mind retail or consumer prices for goods and services.  Truth to tell, that's also what Friedman was mainly talking about too. But there's also such a thing as asset price inflation, when the prices of such things as equities and real estate move sharply higher.  There was plenty of that around during the Greenspan era, and there's no doubt that QE and ultra-low borrowing costs have given us more of the same in the last five years.

Many central bankers are nervous about this asset price bubble, and almost seem to wish that consumer prices would start to perk up, so that they can start to tap on the monetary brakes -- but consumer prices are refusing to cooperate.  Why is that?

If we look back to the Greenspan era at the Federal Reserve, we find a central bank, or at least a central bank Chairman, convinced that expertly-applied monetary policy was the major factor behind the era of consumer price stability.  In truth, there was always much more to it than that.  Greenspan always acknowledged that rising productivity, largely related to the information revolution, played a major role, but he never paid much attention to another key factor: the flood of low-cost, high quality manufactured goods from China and other parts of the developing world. It's arguable that the Chairman of Walmart played a greater role than the Chairman of the Fed in ensuring US price stability in the early years of this century.  

The relative importance of the factors keeping inflation low has changed subtly in the last few years. Cheap Asian imports are still helping, but not as much as they did a decade or so ago.  Strongly rising labour productivity, especially in the US, is now more important, not least because the fruits of that productivity growth are generally not being passed on to workers in the form of higher wages, as routinely happened in the past.  Labour incomes have been largely stagnant for many years, a fact that reflects a number of key changes in labour markets.  These include the rapid spread of "right to work" laws among US states and, increasingly, in other parts of the world; continued outsourcing, both internationally and to lower labour cost jurisdictions; the replacement of full-time jobs by part-time and contract positions, which generally carry fewer benefits; and new union contracts that allow employers to pay new hires much lower wages than the existing workforce.

These developments are all inter-related, and labour unions have found themselves all but powerless to stop them.  The "race to the bottom" for wages and benefits has kept costs of production low, which has directly contributed to the inflation stability that most developed countries continue to experience.  However, it's becoming ever clearer that there's a downside: the absence of wage growth means that domestic demand is growing at a glacial pace in most countries, despite the efforts of central banks to goose it through expansionary policies.

Here, in fact, is the unhappy paradox: for a variety of reasons that have almost nothing to do with central banks,  wildly expansionary monetary policy, both in the Greenspan era and post-financial crisis, has triggered neither inflation nor particularly robust real growth. It has, however, permitted the formation of one asset price bubble after another -- and as we saw back in 2007/8, when those bubbles start to burst, it's deflation and not inflation that policymakers have to worry most about.