December 27, 2014 by Paul Goldsmith
Normally, you would expect the announcement that inflation has fallen as far down as 1% to be greeted with joy. Yet, the Consumer Prices Index’s fall has led economists to start to worry about a different problem: Deflation.
Certainly, the press and the Government have been positive about it. That prices are rising slower than wages are rising can only help with the costs of living. This is particularly resonant given that the fall in inflation is because of the drop in fuel prices (caused by the fall in the price of oil) and the fall in food prices (caused by the current supermarket price wars).
That the fall in inflation was caused by price falls in goods that were so central to the average household’s budget will feel like a tax cut to the public. It means that should Bank of England Governor Mark Carney have to write the letter to Chancellor George Osborne that he will need to write should inflation fall again below 1% (the Bank of England has a target of 2% plus or minus 1%), the letter will not be difficult to write. Any government that has achieved inflation- less economic growth is a government that should be happy with its’ lot. It has even been called an “early Christmas present”.
This is why we have to leave the voices of dissent to economists. The Eurozone is currently battling deflationary pressure, and it is feared this could now happen in the UK.
It is easy for people to think deflation might be a good thing. After all, if prices fall, surely that is to the advantage of the British public right?
Wrong. Deflation can be a disaster for an economy. Deflation works for an economy if prices fall as peoples’ disposable income is rising. But in almost all cases it will be falling. Here’s why.
Deflation discourages consumer spending – think about what you would do if you knew prices were falling. You would delay expenditure wouldn’t you? This is why deflation leads to lower consumer spending and lower economic growth, which could mean unemployment and lower wages. The Japanese ‘deflationary spiral’ that lasted for 20 years started here.
Deflation increases the real interest rate – If you have money in the bank and deflation is 2%, then even if Interest rates are at 0%, you are getting a 2% return on your bank account. So there is an inadvertent tightening of monetary policy. Britain can use quantitative easing to help here, but Eurozone countries can’t. But given more money might be saved, it will reduce consumer spending and again add to the slowing of economic growth.
Deflation increases the real value of debt – If you have debt of £10,000, that amount becomes smaller with inflation, but bigger with deflation. So debtors have more problems paying off their debt. This adds to the fall in consumer spending mentioned above as consumers have less disposable income.
Deflation causes real wage unemployment – Prices are falling for companies, but wages won’t fall. Workers simply won’t accept a fall in nominal wages (wages not taking into account of inflation), even if prices are falling. But that puts companies in a difficult position. Spending is slowing down, and the revenue they get from units sold is falling due to deflation. So companies have little option put to cut costs, raising unemployment. This lowers disposable income, and thus consumption and economic growth.
Worse, as Japan has experienced, once deflation sets in it is difficult to get out of. The fall in demand caused by the consequences above leads to unemployment which leads to a further fall in demand. This is why you can get into a ‘deflationary spiral’, and why the Government and the Bank of England need to be careful about this fall in inflation.
So what should they do? Well, we should see what happens in the near future. The fall in fuel prices is caused by the fall in oil prices, and that could be temporary. If oil prices rise again, so could fuel prices, and inflation could get higher. Supermarket price wars ‘break out’ but don’t often last. So the Government should wait and see if this fall in inflation sets in longer term.
If it does? The Government get the luxury of needing to use policies that might stimulate demand, although it is not that simple. They could use quantitative easing to print money, but what is more likely politically might be some tax cuts. However, there is one problem with tax cuts – the deficit. As Shinzo Abe is discovering in Japan at the moment, trying to combat deflation when you have a debt problem involves macroeconomic conflicts that are extremely difficult to resolve. More on that in a future blog.
So yes, we should be happy with inflation at 1%. But not too happy.