Low inflation: pressure for consumers, a problem for government
THE world used to be a much simpler place. High inflation was bad and low inflation was good. In countries like Germany, where hyperinflation was closely associated with extraordinarily destructive changes in society in the past, this particular creed was understandable and deeply entrenched.
However, the surge in inflation worldwide that followed the oil price shocks of the 1970s meant rapidly rising prices came to be generally regarded as the main threat to prosperity.
Some indication of the importance policymakers attached to curbing that threat is provided by Ronald Reagan's colourful quote that "inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hitman".
You won't find Reagan's description of inflation in most economic textbooks but it gives a strong sense of the support that exists for tough and independent central banks, whose primary purpose is to subdue inflation and thereby protect living standards.
Unfortunately, in Japan in the 1990s and now in the euro area, we may be discovering that the only thing worse than very high inflation is very low inflation.
The most worrying outcome would be a prolonged period of falling prices or 'deflation'. This is particularly threatening because it causes households and firms to postpone their spending and production, which could lead to a downward spiral in activity and incomes.
At present, such an outcome is unlikely although entirely possible if a fragile world economy was to suffer any significant negative shock. And like many economic concerns, this is a problem that is much better prevented than cured.
Traditionally, economists saw deflation and very low but positive inflation as entirely different in their implications. Very low inflation was seen as boosting consumers' spending power. Unfortunately, that is true only if weakness in prices is not associated with weakness in incomes.
In the current environment, low inflation appears to be signalling serious economic problems in the same way that a faint pulse points towards medical difficulties. Just how threatening these problems might be depends on what precisely is driving low inflation.
Across the euro area as a whole, the annual inflation rate is now just 0.7 per cent. While this is partially down to falling energy costs, it testifies both to the weakness of domestic spending power and to the impact of a rising exchange rate which weighs on prices but also worsens the competitive position of euro area firms.
In Frankfurt, the ECB – set up in a manner intended to protect the savings of industrious 'northern' Europeans from the inflationary tendencies of their 'southern' cousins – is struggling hugely to find effective ways of dealing with these unexpected circumstances.
There is little doubt that the current Irish inflation rate of just 0.4 per cent in the year to April is within a range that hints at serious economic difficulties in this country, but handled properly, it could also be part of the resolution of these problems.
Because price levels are relatively high in Ireland compared to many other European countries, Irish costs need to undershoot those abroad for some time. Unfortunately, very low euro area inflation makes this an extended and painful process.
Low Irish inflation is associated with marked weakness in domestic spending power.
The April KBC Bank/ESRI consumer sentiment survey showed that just one in six Irish consumers see their household finances improving in the next 12 months, with twice as many expecting a further deterioration.
Not surprisingly, this is showing up in inflation data in the form of sharp falls in the prices of food, clothing, furnishings and electronics in the past 12 months as retailers battle for the hearts, minds and purses of hard-pressed consumers.
In most instances, price trends in these areas are notably weaker in Ireland than those being seen elsewhere in the euro area and, as such, point towards a painful but hopefully finite rebalancing. However, in many other areas, the squeeze on Irish consumers is being made much worse because of notably larger price hikes than in other countries.
In areas such as insurance, education, electricity, gas and rents, where affected consumers have little scope to delay or avoid outlays, recent Irish price trends have been more typical of an era of very high rather than low inflation.
In a world where prices are generally close to flat, we must ensure that outsized price increases in particular parts of the Irish economy do not reflect excessive taxation, inadequate competition or ineffective regulation. This will be a key task for Government over the next few years if we are to see a return to sustainable increases in the spending power of Irish households.
- Austin Hughes is chief economist with KBC Bank
Sunday Indo Business