“Papa Bear” - Inflation Let me start with “papa bear” inflation. On conventional wisdom, he should be making an appearance by now. Historically, inflation comes from high wage growth in a tight labour market during the late stages of the business cycle – a relationship economists describe as the Phillips Curve. Cyclical conditions are now tight in major economies, especially in the US. US unemployment rate has fallen to 4.1%, well below the Fed’s estimated Non2/7  BIS central bankers' speeches  Accelerating Inflation Rate of Unemployment (NAIRU) of 4.6%. Yet, wage growth has remained at around 2.5%, below the pre-crisis average of 3.5%. Whenever central bankers gather these days, this phenomenon of “missing inflation” is often the main topic of discussion. Many wonder whether the Philips Curve has permanently flattened – meaning whether the negative relationship between the unemployment rate and wage growth has fundamentally weakened. Some even ask if the Philips Curve is dead – if the relationship no longer exists. Why has “papa bear” inflation been missing to-date? The first and simplest explanation is that the headline measure of unemployment may be understating the level of slack in the economy. In the US, the IMF estimates that the output gap between actual and potential GDP has only just closed. The output gaps in the EU and Japan are still some way off from closing. There may also be quite some slack in the labour market that may not be fully apparent.
A financial crisis is a sure way of thwarting economic growth, as we saw nine years ago. What is the risk now? From one perspective, the wide-ranging post-crisis regulatory reforms have made the global financial system more robust and resilient. Large banks are stronger, more liquid, less leveraged. Derivative markets are safer, with central clearing covering more than 90% of OTC derivatives trades in the major jurisdictions. Yet, from another perspective, the risk of financial instability is not small. This is mainly due to the build-up of leverage in recent years. In the G7 economies, the ratio of government debt to GDP has increased by 45 percentage points since the crisis and is now at its highest since World War II. 5/7  BIS central bankers' speeches  In emerging Asia, corporate debt issuance has ramped up to about $ billion p.a. since 2014, three times the average volume in the preceding five years. Household debt has built up sharply in many advanced as well as emerging market economies, with escalating house prices a key driver. High leverage is a risk factor for financial instability. I spoke earlier about how an increase in interest rates in a high leverage environment can create debt servicing pressures. If these pressures lead to widespread credit defaults, financial instability is usually not far off. Another channel of causation from high leverage to financial instability is through sharp corrections in asset prices, particularly real estate prices.