Earlier this year inflation was a big worry, now with inflation fading rapidly around the world there is more and more talk of deflation. The AMP’s Dr Shane Oliver looks at the situation and why we need the US Fed and its chairman, Ben Bernanke to succeed making sure deflation doesn’t grab control in 2009.
Global inflation is falling rapidly due to falling oil prices and the economic slump. Next year inflation may turn into deflation, i.e., generalised price falls.
- Sustained and uncontrolled deflation would be bad news as it would accentuate problems associated with high debt levels and falling asset prices.
- However, the US Federal Reserve seems to be well aware of the risks and has indicated it will do everything possible to head off a deflationary spiral. It is already embarking on quantitative easing (or “printing money”).
From inflation worries to deflation worries 2008 has certainly been an odd year. At the start of the year inflation was a big worry.
Now deflation is rapidly becoming a worry as inflation rates around the world are plunging towards zero.
So what is deflation? Why is it a problem? What is driving it? What does it mean for investors? And how likely is sustained deflation?
Deflation – what is it?
Deflation refers to persistent and generalised falls in prices.
In other words, the underlying consumer price index would decline.
A long run of history shows that deflation is not a particularly unusual phenomenon. Deflation occurred in the 1800s, 1930s and more recently in Japan.
However, whether deflation is a good thing or not depends on the circumstances in which it occurs.
Lower prices are good for consumers because they increase the purchasing power of their income, but not if they are associated with falling wages, rising unemployment and falling asset prices.
For example, in the 1930s and more recently in Japan, deflation reflected economic collapse and rising unemployment made worse by the combination of high debt levels and falling asset prices (“bad deflation”).
In the current environment deflation could cause serious problems because household debt levels are high in many countries.
Sustained deflation would increase the real value of debt at a time when asset prices are falling and nominal incomes are weakening.
If individuals attempt to reduce their debt burden by cutting spending (which only intensifies deflationary pressures) and selling assets (causing further falls in asset prices), the risk is that a vicious “debt deflation” spiral may take hold.
But not all deflation is bad. In the period 1870-1895 in the US, deflation occurred against the background of strong economic growth, reflecting rapid productivity growth and technological innovation, i.e. “good deflation”.
Falling prices for electronic goods are an example of good deflation.
Potential drivers of deflation
Right now, given the global economic slump, high household debt levels in key countries and falling asset prices, the main concern is that we will see a bout of “bad deflation”. The past few months have seen headline inflation rates fall sharply.
US inflation has fallen from a peak of 5.6% over the year to July to just 1.1% over the year to November and its still falling.
So far Chinese inflation has fallen from a peak of 8.5% in April to 2.4% in November.
Inflation is also rolling over in Europe and Japan and based on the TD Securities Inflation Gauge is also starting to fall in Australia.
So far the main driver of the slump in inflation has been falling oil and food prices, but underlying inflationary pressures have also turned as companies are turning to discounting to sell goods in the face of weak demand.
Indications are that inflation will fall further. For example, a survey of US manufacturers in terms of the prices they are paying for inputs has fallen to its lowest level since 1949. This points to US inflation falling into negative territory early in 2009. See next chart.
Similarly inflation is likely to fall in other countries leading to deflation worries next year.
There are two key drivers:
- Firstly, the slump in commodity prices, particularly oil, is cutting inflation directly via lower petrol prices and indirectly via lower raw material prices.
- Secondly, underlying inflation pressures will fall in normal lagged response to the global recession.
This is because the recession will lead to global spare capacity and this leads to discounting putting downward pressure on prices (or the rate of increases in prices).
Excess capacity in Chinese factories will also see China return to its position of exporting deflation to the rest of the world in order to help keep its exports up.
The US recessions of the mid-70s, early 80s and early 90s were associated with falls in US inflation excluding food and energy of six, nine and 2.5 percentage points respectively.
A 2.5 percentage point fall in US core inflation from its recent peak would take it to zero.
Deflationary forces will also be felt in Australia as global prices fall and excess capacity opens up due to the slump in local growth.
This may be partly offset by the lower $A pushing up import prices and the (hopefully) milder recession locally
