Why is global inflation so low

One can only guess what the European Central Bank will decide at its meeting next week. But the reason for what it then decides is already clear. ECB President Christine Lagarde will lead the low inflation in the euro zone into the field to justify the bailout program worth billions and the adherence to the zero interest rate policy.

Central banks are supposed to ensure that prices remain stable, and it has been agreed since the 1990s that price stability is given with an average inflation rate of two percent. That made sense, because in the past inflation rates in the western industrialized countries were at times five and more percent. But for years, inflation has been well below two percent, even though the monetary authorities are pursuing the loosest monetary policy of all time. The inflation rate in Germany was zero percent in August, as the Federal Statistical Office announced on Monday.

While economics rackets its brains as to why prices have stopped rising, many consumers are sure that prices have gone up, and strong.

The inflation rate is a deeply individual experience. It often deviates from the officially measured number, which is based on a shopping cart that also includes goods that some people do not or rarely buy. In its regular surveys, the EU Commission has found that citizens perceive the inflation rates to be much higher than the EU statistics agency Eurostat regularly reports. The official rate of inflation in 2019 was one percent, but people estimated their perceived inflation to be around six percent (see grafic).

The discussion about perceived inflation picked up speed with the introduction of the euro. Many consumers had the feeling that prices had risen by 100 percent with the changeover from the D-Mark to the Euro. The official inflation rate did not reflect this impression at the time; to this day there is a blatant gap between perception and official measurement, which could also be due to the fact that the measurement method has a social list.

"The price increases in Europe have been at the expense of poorer people in recent years, but the official inflation rate does not express this effect," says Alfons Weichenrieder, professor of finance at the Goethe University in Frankfurt. In his study, which refers to the years 2001 to 2015, Weichenrieder found that necessary expenses, for example for food, rent and energy, make up a larger proportion of their budget for less financially strong families than for richer families. If the prices for such goods rose faster than those of luxury products, this would mean that households with low incomes would have to accept higher price increases on their individual shopping carts. The measurement for Germany revealed that the shopping carts of the bottom ten percent of the population in terms of income were around 4.5 percent more expensive than the shopping carts of the top ten percent in terms of income.

"The low inflation reflects the reduced purchasing power of many households."

When the official inflation measurement is carried out, statisticians make a so-called quality adjustment. This means: If a product has become more expensive, but at the same time improved in quality, only part of the price increase is included in the measurement. An example: In 1999 an average new car cost 18,500 euros. In 2019, the average new price was 34,000 euros. This corresponds to a price increase of 84 percent, but the consumer price statistics only show an inflation rate of 22 percent. "One problem is that the customer no longer has the choice between the simple, inexpensive and the better-equipped, expensive product," says Gunther Schnabl, Professor of Economic Policy at the University of Leipzig, who calculated this example. The purchasing power of the customer is weakened because he has to buy the new product with more functions, even if he does not want them at all. An illusion of low inflation is created, an effect that increases because it is qualitydeteriorations would not be taken into account in the official inflation measurement.

"People rightly feel that a lot is becoming more expensive, for example a lot of food. In addition, wages are no longer rising as much as they used to be, or are even falling," says Schnabl. This is why more and more people are buying cheaper products from discounters, for example, which is likely to increase the weighting of cheap goods in Eurostat's shopping basket, so that measured inflation will be low. "It used to be said: Low inflation preserves purchasing power. Today, in a certain way, it is the other way around," said Schnabl. "The low inflation reflects the reduced purchasing power of many households, which tend to buy cheap products of often lower quality."

In detail, the debate about the "correct" inflation rate is very complicated, but the subject is explosive, especially in Germany, where the ECB's loose monetary policy has long been controversial. "The inflation rate, often rightly perceived by the poor as high, could undermine people's confidence in the ECB because the central bank only focuses on an average inflation rate," says Weichenrieder, a financial scientist.

The following aspect shows how piquant the topic is from a financial policy perspective: "The officially low inflation rate saves the state a lot of money, because if inflation were higher, wages, welfare and pensions would have to rise accordingly," says Schnabl. "You would need different inflation rates to get closer to reality and better reflect people's feelings."