Central banks are struggling to account for the persistence of low inflation despite trillions of dollars of monetary stimulus and tighter labour markets. Their explanations centre on the disinflationary effect of globalised product, capital and labour markets on shifting the Phillips curve, the inverse relationship between unemployment and inflation. It is widely acknowledged that tighter labour markets in a given country no longer result in the expected rise in inflation, because global rather than domestic slack has become a fundamental determinant of prices.
Monetary policy-makers see ever-larger stimulus, for the sake of adding a few extra basis points to inflation, as not worth the financial risk. Structural changes in the global economy add urgency to this reassessment.
Over the last few decades the services sector has risen steadily both as a share of global GDP and employment. Many of these sectors are increasingly knowledge- and technology-driven. This has had a dramatic impact on economic organisation, productivity, costs and product quality, which may have lowered the inflationary pressures of economic growth and low unemployment. Difficulties in measurement mean these issues are often overlooked, but their influence on monetary policy transmission could be substantial.
The internet has made many functions that were previously paid for, such as communication, entertainment, information and news, effectively free. This means a large amount of economic activity no longer appears in GDP figures.
With output becoming more difficult to measure accurately, productivity gains may be under-reported. In late January the UK Office for National Statistics revised its estimates for productivity and sectoral growth upwards after acknowledging that advances in digital technologies and communications services had not been captured by official figures. Inflation, meanwhile, was lower than reported, reflecting the adjusted value of the services produced.
These difficulties represent a significant break from the past, where producing more of a given good or service required greater demand for physical inputs, pushing up aggregate demand. This ensured a strong link between economic slack and inflation, and allowed central banks to manage price levels via traditional monetary policy tools.
The digital economy is more dependent on intangibles that have a less direct influence on aggregate demand. Many services are produced and distributed using software rather than requiring physical inputs, supply networks and bricks-and-mortar outlets. This is making the marginal cost of new production essentially zero.
The extent to which this has affected the link between potential output, inflation and monetary policy is still unclear, but the break with experience is striking.
Data-driven services have allowed dramatic improvements in quality, although these are often hard to quantify. As a result, it can be misleading to compare the price of items over time, creating difficulties for the year-on-year nature of inflation measures. An iPhone may be much more expensive than an outmoded mobile phone, but it offers much greater functionality. Improvements in technology and communications have similarly transformed low-tech sectors such as food delivery and transportation, further hindering comparison.
Central bank models depend on historical data to guide their forecasts. The rapid growth of the digital economy and technology-enabled services is creating a new reality to which policy-makers must adapt. Updated models using assumptions based on services output, quality, prices and productivity gains are needed. The lack of hard data here suggests one reason why inflation has consistently undershot forecasts and why monetary policy has been so slow to achieve its target.
Policy-makers are trying to understand the true impact of the evolving digital and service-based economy on inflation dynamics. Until they succeed, the risk of inappropriate or potentially harmful choices could grow.
Ben Robinson is Senior Economist at OMFIF. This article first appeared in the February edition of The Bulletin.