Sunday 22 April 2018

Low inflation means low interest rates for 2014 and beyond

In the mid-1930s, consumer prices in Ireland were lower than they had been at independence in 1922. That period of deflation largely coincided with the Great Depression, an economic era much worse even than the past half-decade of gloom.

But then deflation turned to inflation and prices rose almost uninterruptedly decade after decade until the economy crashed in 2008. In the following two years, Irish prices fell by more than at any time since the 1930s. The price level for consumer goods and services in the Irish economy is today almost identical to the level all of six years ago (see chart).

As the new year begins, historically unusual price developments -- or, more precisely, the threat of such developments -- are causing much debate in economic circles.

Could prices start falling in 2014? Is the eurozone really at risk of "deflation"?

Could the continent get trapped into the kind of deflationary trap that has dogged Japan for more than two decades or Ireland after independence? And what does it all mean for Irish households and businesses?

Let's start by saying that economists have only a limited understanding of inflation and its causes. This is illustrated well by the very different views taken in the profession on the effects of on-going money printing by central banks.

Some economists believe that printing so much money will eventually lead to hyper-inflation, while others advocate printing more of the stuff to reduce the risk of deflation.

But if economists disagree on inflation and its causes, they agree that deflation is very dangerous because history shows it is very difficult for policy-makers to get economies out of deflationary traps -- the Japanese have been trying for almost a quarter of a century.


There are many things that we should worry about in the new year -- a flaring up of the eurozone crisis, yet more problems with the wretched banks and a withering of the green shoots of recovery -- but price instability should be well down the list of concerns.

Trends in prices and the factors that drive them do not appear at this juncture to suggest there is an imminent danger of deflation (and none whatsoever of runaway inflation, despite the warnings of those hostile to money printing).

Consider the data first. The accompanying chart shows trends in core consumer prices, excluding volatile energy prices and seasonal food, since 2008.

In the eurozone, prices in the year after the crisis broke out (from late 2008) stopped rising. The deepest recession in living memory sapped demand for goods and services. But despite the scale of shock, it did not cause prices to fall across the continent (as is clear from the chart, Ireland's exceptionally deep slump caused an exceptional and unique decline in the price level here).

From early 2010, when the eurozone emerged from the Great Recession, the rate of price rises resumed its slow upward trend. And despite being in a protracted period of sluggishness over the past two years, there has only been a moderate deceleration in the rate of inflation of late.

More importantly, there has been no outright deflation -- as the chart illustrates prices across the eurozone continued to rise until November (the most recent month for which figures are available).

And even in the weakest economies of the periphery, including Ireland and the Mediterraneans, there has been no deflationary spiral.

With some signs of recovery almost everywhere in the euro area, fears of deflation seem particularly overdone.

But if the real economy in Europe is looking better going into 2014, nobody expects the eurozone to take off like a rocket. As a result, demand pressures will remain weak. Add to that the strong euro, which dampens the prices of imported goods, such as oil, the most likely outcome for the medium term is continued very low inflation.

This should come as music to the ears of those whose debts are on variable interest rates, and indeed anyone who cares about this economy's recovery. Among the worst possible things that could happen in the foreseeable future is for the European Central Bank to raise interest rates back towards historically normal levels.

That is because Ireland has very high levels of household and company debt, either by the standards of the past or of any other country in the world today. Ireland is also unusual in that a high proportion of debt has been borrowed on variable interest rates, which are ultimately linked to the ECB's base rate.

A return of interest rates to more normal levels would cause the costs of servicing those debts to soar. That in turn would drain massive amounts out of the economy and in some cases tip those who are just about managing to service their debts over the edge.

If there is good news for the heavily indebted for the year to come and beyond, it is that the probability of soaring debt-servicing costs is low.

Irish Independent

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