The new bogey
Falling inflation is a worldwide worry
MANY nasty things start with a D: disaster, disease, debt and depression, for a start. But economists' current favourite “D nasty” is deflation. For most
The new bogey
Falling inflation is a worldwide worry
MANY nasty things start with a D: disaster, disease, debt and depression, for a start. But economists' current favourite “D nasty” is deflation. For most of the past three decades, central banks have fought inflation. Now some face the even greater evil of deflation, or falling prices.
Figures out on November 16th are widely expected to show that American consumer prices fell in October. Over the past six months, they have risen at an annual rate of around 1%. Producer prices plunged by 1.6% in October, the biggest monthly fall since records began in the 1940s. This was only partly due to the weak price of oil; prices of other goods are falling too. The latest (widely watched) poll by the University of Michigan found that consumers expected inflation of only 0.4% over the year ahead, the lowest expectation since the 1950s.
Over the past year, producer prices have fallen in all the other big economies. Japanese consumer prices have been falling on and off since 1995, and much of the rest of East Asia—notably China and Hong Kong—has been experiencing mild deflation. Hong Kong's consumer prices have been falling continuously for three years.
The word deflation is often misused. Most developed countries other than Japan are so far experiencing disinflation (a fall in the rate of inflation), not outright deflation (a fall in the level of prices). Yet inflation is likely to fall further from already low levels over the next year as the recession bites—raising the chance of deflation. Even when economies start to pick up, inflation usually continues to fall so long as there is ample spare capacity. By one estimate, the global output gap (the difference between actual and potential GDP if the economy were running at full capacity) is now bigger than at any time since the 1930s. J.P. Morgan Chase forecasts that average inflation in developed economies will fall below 1% next year, the lowest for around half a century.
There are two forms of deflation. The friendly sort is when new technology and rapid productivity growth push down prices, as in the computer and telecoms industries. This boosts real incomes and spending power. The second (dangerous) variety is caused by a slump in demand and huge excess capacity, which can trigger a downward spiral of falling prices, shrinking demand and financial distress. The friendly type has been evident for several years, but now there are signs that the malign sort may be spreading.
Such deflation can harm economies in four ways. First, it swells the real burden of debt, causing bankruptcies and bank failures. Second, expectations that prices will be lower tomorrow may encourage households to postpone their spending. Weaker demand may then push prices even lower. Third, workers are often reluctant to accept a pay cut in nominal terms, so that when prices are falling the real wage bill goes up. The only way to cut costs is to lay off more workers, which may deepen a recession. Last, but by no means least, interest rates cannot go below zero, so deflation makes real interest rates painfully high—as Japan has discovered.
Much has been made of the fact that American interest rates, at 2%, are at their lowest for 40 years. But if deflated by inflationary expectations, real rates are still significantly positive. In previous recessions, real rates have usually turned negative.
A 1930s style deflation, when American prices fell by 25% in all, remains highly unlikely. That was due to serious policy errors that are unlikely to be repeated—except, perhaps, by the Bank of Japan. But if this global recession turns out to be deeper than expected, it will reopen the question of whether central banks have pushed inflation too low in recent years.
Everybody agrees that high inflation damages economic growth, but there is a dispute about the optimal rate of inflation. The European Central Bank has an inflation target of 0-2% and the Bank of England's is 2.5%—probably the same as the Fed's unpublished goal. But some say that economies work better with a bit more inflation, say 3-4%. Their argument is that during a severe downturn such inflation makes it easier to cut real wages and to push real interest rates below zero, thereby helping recovery.
Most of the world's major economies now have