A remarkable feature of the past decade has been the stability of global “core” inflation. Headline inflation has fluctuated significantly as a result of commodity price swings but the annual increase in G7 consumer prices excluding food and energy has been confined within a narrow range of 0.7% to 2.0%, averaging 1.5% – see chart. The latest reading, for August, was 1.5%.

Supporters of current central bank orthodoxy might cite this stability as evidence of the success of inflation-targeting. The aim of policy, however, has been to maintain steady, low inflation by ensuring smooth economic growth in line with potential, avoiding booms and busts. The reality, of course, has been far removed from this ideal. Inflation has been stable despite central bankers’ failure to limit economic and financial volatility.

The observed stability contradicts the dominant “Phillips curve” understanding of the inflation process, to which central bankers continue to appeal to justify their policy decisions. This asserts that inflation trends higher when the “output gap” – the deviation of GDP from its potential level – is positive, and lower when it is negative. While there are huge measurement uncertainties, few would dispute that the output gap was significantly positive at the peak of the credit bubble in 2007 and heavily negative at the bottom of the “great recession” in 2009. Yet G7 core inflation was stable in 2007-08 and fell only modestly in 2009-10, recovering in 2011 when the gap was still, presumably, negative.

An alternative monetarist view is that inflation follows swings in money growth with a long lag. This is true of large and sustained changes in money growth, such as occurred in the 1960s / 1970s (up) and 1980s / 1990s (down). G7 money growth, however, has shown no clear trend since the 1990s and there has been limited pass-through of short-term fluctuations to core inflation.

The stability of core inflation, and trend money growth, suggests little risk of “deflation”. With inflation “anchored”, central banks should give greater weight to financial stability and medium-term growth objectives in setting policy. This argues for raising interest rates to encourage saving and deter financial speculation and capital misallocation.