Between the Lines: Deflation is not the treat, its the succeeding inflation

Published on Tuesday 21 April 2009 21:23

INFLATION, as measured by the Retail Prices Index (RPI), went negative in March for the first time since 1960. Admittedly, the annualised drop is a miniscule 0.4 per cent, but that is still means the average price level was lower than a year previously. Does this herald deflation and should we be worried?

The phenomenon is catching. US consumer prices were also 0.4 per cent lower last month compared with March 2008, the first year-on-year drop in America since August 1955.

My gut reaction is not to panic and that this is a temporary situation. For a start, the sharp downward trend in global consumer prices has a lot to do with the temporary collapse in oil prices. US consumer energy bills have plunged 23 per cent in the 12 months since March 2008. Similarly, in the UK the biggest downward pressure on inflation has come from falling energy prices. This will continue to impact on the RPI for months to come.

The second point to note is that, on other price measures, inflation is still very much with us. The RPI takes in mortgage costs, which have fallen following sharp cuts in the rate of interest. But the Consumer Prices Index (CPI), which excludes mortgage payments, is still rising at an annualised 2.9 per cent. The reason is obvious: the dramatic fall in the exchange value of the pound since last year has driven up the cost of imports. This alone will halt a slide into deflation.

The contemporary angst regarding deflation is based on a warped memory of what happened during the Great Depression and a misreading of events in Japan in the 1990s. The fear is that falling prices will lead consumers to delay spending (in the hope of bargains to come) and so accelerate the recession. This is supposed to be what happened in Japan, during its "lost decade" 20 years ago.

There was serious deflation in the 1930s, during the Great Depression, but it had a very specific technical cause: a catastrophic and unnecessary fall in the money supply. This resulted from banks failing and governments raising interest rates. This, in turn, produced a credit crunch. Result: a fall in trade and consumer spending. The only thing that could change in order to bring supply and demand back into equilibrium was a fall in the price level.

Fortunately, this is a lesson well learned and in the present emergency governments have moved heaven and earth to reverse any fall in the money supply and cut interest rates. In January, broad money supply in the UK (known as M4) was growing at an annualised rate of 17.5 per cent, up from 16.2 per cent in December. By February, the rate of increase was 18.8 per cent. And that was before the Bank began its massive printing of money, known as quantitative easing.

The situation in the US is less clear, as (unhelpfully) the Federal Reserve stopped publishing broad money statistics in 2006. However, most independent analysts think the rate of increase is still healthily positive, though it might have decelerated in the past year. However, the narrower money stock has been expanding exponentially, under stimulus from the Fed, and this should feed through at some point. As long as the dollar remains the world's major reserve currency, I can't see any serious, long-term deflation on the horizon.

As for the recent Japanese experience, it is true that consumers have been reluctant to spend money for the past 20 years. Even well-off Japanese households now use old bath water to do their laundry, to save on utility bills. Sales of imported whisky have fallen to a fifth of their peak. But none of this is to do with consumers going on strike because they are waiting for prices to drop even further. If anything, the consumer strike held prices in check.

As a result of the recession of the early 1990s, and to compete with Taiwan and South Korea, Japanese companies were forced cut real wages and replace much of their workforce with temporary employees with fewer benefits. These non-traditional workers now make up more than a third of Japan's labour force. Nearly half of workers aged 24 or younger are temps. This revolution is at the heart of the cap on Japanese consumer spending.

So far, I see no signs that this restructuring of the workforce is happening in America or Europe. Wages in the US are still rising, despite the recession. UK retail figures are not wonderful, but neither has there been a collapse in consumer spending, as Tesco's latest profit figures indicate. Once manufacturing stocks are used up, I think we will see a sudden rebound in output sometime in 2010.

In these circumstances, my real fear is that inflation will ignite. Hosing the economy with money to fight off deflation is necessary in the short run. But if we get into a funk about non-existent deflation and central banks keep printing money just as the recovery is starting, prices will leap. Commercial banks will start to convert their inflated central bank reserves into cheap loans and governments – fearful of hindering recovery – might lack the discipline to stop them.

Forget about a second Great Depression. Worry about the Great Inflation.