Low inflation a puzzle for central bankers

You'd think that low inflation is a dream come true for central bankers. Instead, they are perplexed. Economic theory would argue that three years of soaring commodity prices, global growth at its strongest in three decades, falling unemployment rates and factories working at full tilt is a textbook case for global inflation to pick up.
The reality is quite different. Inflation in advanced countries has tumbled from 7 percent on average in the 1980s to 2 percent this decade. In emerging markets, it has fallen from 9 percent to 4 percent over the same period, according to the International Monetary Fund. The pattern shows signs of continuing. The global all-industry PMI index for February showed input cost inflation fell in February to a four-month low. In Europe inflation has surprised by remaining below 2 percent for six straight months.
More perplexing is that inflation has beat a retreat despite very loose monetary conditions. The Bank for International Settlements estimates that central bank money in the world's 16 most developed countries after adjusting for inflation has been below the neutral rate ever since 1998 - in other words, at levels that usually are viewed as likely to fuel inflationary pressures.
A number of economists, including those at the BIS which acts as a bank for central banks and a leading monetary think tank, argue that global inflationary dynamics have changed. Low inflationary dynamics allowed major central banks to keep rates at record lows in the 2002-2004 period and now to tighten policy by less than in previous business cycles.
In the United States the Fed has paused at 5.25 percent, 125 basis points below its 2000 peak. The ECB is expected to stop tightening at 4 percent, 75 basis points below its previous peak and the Bank of England at 5.5 percent, 2 percent lower. The reasons are the same for all major economies.
Eastern Europe, China and India joining the world economy has brought lots of slack into labour and product markets, pushing down prices. Hence, domestic slack plays a much smaller role in determining national inflation rates today.
Secondly, central banks have earned credibility. Businesses and consumers are far more confident today that prices will remain low compared with 20 years ago so they push up wages and prices far less quickly than in previous decades.
Thirdly, deregulation and highly competitive financial markets makes capital cheap. Investment in labour-saving technologies has risen and with it labour productivity, lowering unit labour costs. Inflation stays in check as growth quickens. The problem for central bankers is evaluating whether these factors amount to a permanent break in how inflation behaves, or whether it's only temporary.