Sunday 25 September 2016

Don't worry about deflation, just enjoy the fall in prices while it lasts

Published 09/04/2015 | 02:30

This morning, at 11 o'clock, it is very likely to be revealed that the price of a basket of consumer goods last month was lower than in March of last year. If the State's statisticians confirm that prices are falling, it will be in keeping with a trend in evidence since December, when a period of "negative" inflation began.

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By the standards of the past 80 years or so, any decline in consumer prices is a rare occurrence. Rarer still is the fact that prices are lower today than they were seven years ago, just as the economy began imploding. One has to go back to the dark 1930s to find such a protracted period of "deflation".

Despite plenty of hand-wringing about the downsides of falling prices among economists, recent inflationary trends have been good for nearly everyone. They have been bad for almost nobody.

While there is some reason to be concerned about falling prices, most people's intuitive sense - that lower prices are a good thing - is correct. For now at least.

Fear of deflation has two pillars. The first is that if prices fall, or if they look like they are heading in that direction, people will put off making purchases in the hope of getting a better deal in the future. If many people postpone spending, demand drains from the economy. This can become a hard-to-break, vicious circle of deflation.

That's the theory.

But in practice, spending in the shops has been growing quite strongly both in Ireland and across the euro area in recent months.

There is not a shred of evidence to suggest that the average Irish or European Joe is holding off buying the new flat screen he covets (or anything else for that matter) because he thinks he might get it a little cheaper in six months' time.

One reason that there is no sign of a deflationary spiral taking hold is because wages are not following prices downwards - and it is only when wages start falling that there is something to really worry about when it comes to deflation.

But that is not happening. Indeed, it could be said that we, in Ireland, are currently enjoying the best of both worlds - falling prices and rising wages. At the end of last year, just as inflation turned negative, the first signs of rising average salaries across the economy were registered.

You don't need a degree in economics to know that if your income stays stable and prices fall you are better off.

If you throw in a pay hike on top of that, you are considerably better off.

That happy situation has been pertaining recently, and it may explain why consumer confidence has soared to levels last recorded in the spring of 2006.

With the jobs market continuing to improve and more sectors experiencing skills shortages, my bet is that the awakening of wage growth is just beginning and more people can therefore look forward to pay hikes over the rest of the year. If that proves to be the case, there is even less reason to worry about falling prices.

A second reason economists fret about a deflationary spiral - which, remember, necessarily involves falling wages - is that it makes debts harder to repay.

Because the average level of Irish household debt is still extremely high by historical and peer country standards, significant deflation would be a particularly serious problem for this economy.

But that is nowhere close to happening, so that concern can also be put to bed.

There are yet more reasons not to worry about the small declines in prices observed recently.

One is because the (small) fall in prices observed in recent months has mostly been caused by the near halving in oil prices in recent times.

Until the middle of last year, a barrel of oil cost over $100. In 2015, so far, it has been hovering at around $60.

Lower energy prices have had a big impact on inflation everywhere, and we in Ireland are no exception.

When energy costs are stripped out of the overall consumer price index, Ireland's deflation disappears.

In other words, the average price of a basket of goods excluding energy prices is still rising, if at a very low level.

It should also be said that falling energy prices are good for the Irish economy and in no way bad.

They are equivalent to a tax cut, freeing up more disposable income.

The losers are in mostly distant oil exporting nations (and that the Putins and the Ayatollahs of this world have less spare cash to cause mischief with is hardly a matter of regret for most of the planet).

If all that has not convinced you that the much feared deflationary death spiral is not at hand, then consider what's happening in Frankfurt.

The European Central Bank's decision to begin "Quantitative Easing" (QE, which, for all intents and purposes, is the printing of more money) earlier in the year was designed to ward off the threat of deflation.

It has started well, not least because it had an immediate impact on one of the determinants of prices - the exchange rate.

Because QE leads to an increase in the supply of euros, the price of the euro in other currencies falls, all other things being equal.

The mere anticipation of this effect has caused one of the sharpest declines in the euro since its creation.

Against sterling, the euro is down more than 10pc since this time last year, while the fall vis a vis the dollar has been considerably greater - at almost one quarter.

This means that the price of goods imported from Britain and America will rise.

Because Ireland imports so much from these two countries - almost half of total imports - the impact of euro depreciation can be expected to be bigger here than in the rest of the bloc.

Given the positive domestic situation and signs of a recovery taking hold across the eurozone, the small risk of deflation is receding further.

The small declines in prices in recent times probably won't go on much longer. Enjoy them while they last.

Irish Independent

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