Friday 30 September 2016

Economists may worry about deflation but I'm not so sure

Published 15/05/2014 | 02:30

'There are other dangers from falling prices'
'There are other dangers from falling prices'

ONE has tried hard, very hard, to worry about deflation, but it isn't easy. For a start, one is not a debtor. For governments, or those on tracker mortgages, the low interest rates that accompany near-zero inflation help offset the slow fall in the real value of their debt. But inflation would be quicker.

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But even for savers, the "financial repression", from ultra-low interest rates seems not as alarming as the very rapid reductions in the real value of savings produced by high inflation. Especially if that has been the perceived danger for most of one's life.

It is not just debt, though. There are other dangers from falling prices, or even disinflation – where prices are rising hardly at all.

The main one is the postponement of purchases on the grounds that things will be no dearer, and maybe even cheaper, if the purchaser waits. This, in turn depresses economic activity, leading firms to cut costs and wages so as to reduce prices, thereby adding to the deflationary circle.

And yet, when one has spent a lifetime worrying, and writing, about inflation, it is hard not to find merit in the stability that recent years has brought to household expenditure. It is, however, a slippery business.

One of the causes of the asset price bubble and crash of the 2000s was that consumer price inflation was very subdued, thanks largely to the flood of cheap manufactures from China. Since this was the target for most central banks, it allowed them to ignore rampant asset price rises, with disastrous consequences.

This is one of many things that the worst crash in 80 years has done surprisingly little to change. Central banks still quote consumer prices more often than anything else.

They still feel unable to decide on a desirable target for asset prices in the way they do so blithely with shop prices. People buying fridges have less clout than hedge funds, although it must now be open to question as to whose activities are the more dangerous.

Remarkably, the central banks of the UK and US have chosen unemployment as a key target. It may be a good idea – only time will tell – but it is still remarkable. They have backed away form traditional financial objectives such as money supply and are unwilling to try new ones, such as value of output (nominal GDP). This has always seemed one of the more convincing measures, so that probably rules it out.

Meanwhile, prices remain stagnant and interest rates – to banks at least – negligible. The "quantitative easing" undertaken by those two central banks, which mainly consists of buying mortgage-related debt from banks, may have prevented outright deflation but a return to historically normal inflation rates seems as far away as ever.

There has been less action from the ECB. To some, that helps explain why the eurozone faces the biggest threat from deflation, according to the OECD. Within the euro area, the indebted countries, such as Ireland, face the biggest threat.

The report takes a look at where the downward price pressures are most intense. The biggest contributors to OECD "disinflation", where prices are rising, but much more slowly than before, are in energy and food. In some ways that reinforces the feeling that perhaps we shouldn't worry too much.

The decline in energy price rises in the past two years accounts for around 1 1/4 percentage points of the fall in OECD headline inflation since the peak in September 2011. It was particularly marked in Europe.

Food prices account for a further quarter percentage point, with the annual increase across the OECD running at the historically low rate of 1.7pc. The report suggests this trend may not continue, with food commodity prices on the rise this year.

Aside from these, all other goods and services account for just a quarter percentage point fall in OECD-wide inflation. There is also the fact that higher indirect taxes and charges imposed early in the crisis no longer add to annual inflation.

Given that food and energy are often excluded from some analysis, because of their volatility, and taxes are taxes, it would seem that perhaps there is not too much to worry about.

Except that, while the figure may be small, the OECD reckons that the fall is due to "sizeable domestic economic slack", meaning that demand for goods and services is less than the amount which business could supply. That keeps prices down. Subdued import price growth – the China factor is still present – has also contributed.

The OECD is concerned by disinflationary pressures in the core eurozone countries, which were not subject to the ferocious deflationary pressures in the busted peripheral countries. Inflation in France and Germany, is now 0.7pc and 1.1pc. That compares with Ireland's figures for April, which had annual inflation at 0.4pc and no overall price rise during the month.

The danger, the OECD says, includes that any renewed economic weakness, further appreciation of the euro, declines in commodity prices, or a reduction in people's inflation expectations. This could result in a period of eurozone deflation, with all of the those dangerous effects on debt and demand.

The ECB's response last week was to more or less promise another rate cut next month. They may even go negative, with banks being charged to leave money in Frankfurt, rather than being paid. That might still be too radical for some in the ECB and it would be a big surprise if it would go as far as buying up private sector debt, such as corporate bonds or the once-infamous securities backed by assets like mortgages.

Yet there is wide agreement, from the new hard-money theorists to conventional economists, that the ECB's past policy of putting cash into bank coffers will do little for either growth or inflation.

One cannot avoid the thought that had the ECB actually followed one of its key targets – money supply – during both the boom and now, its policy would have been much more appropriate.

Be careful what you wish for. There is no convincing evidence that central banks can control inflation with any precision. Most of the time it will be higher than they would like and occasionally, as now, lower.

We savers are right to be fearful of rising prices, but maybe they are now something to be wished for.

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