Deflation runs deeper

The annual rate of deflation in Ireland fell to 4.7% in May. The figures released by the CSO relate to the period June 2008 - May 2009. This was the biggest fall since 1933 and compares with an annual deflation rate of 3.5% in April. Directly compared with April prices fell by 0.5%. The main reasons for this were falls in mortgage repayments (due to as April's interest rate cut by the ECB). Rents also fell, while there was a reduction in electricity and gas costs.

Deflation Q&A

The London Times is running regular briefings to coincide with 'Target Two Point Zero', the Bank of England contest for English sixth-formers run in conjunction with the newspaper. The competition challenges students to play the role of the Bank's Monetary Policy Committee (MPC) and recommend the best level for interest rates. This week's topic is one we have already written a lot about - deflation. Unfortunately, we cannot enter the competition but the article is a good one and deals with an issue I mentioned in class to the Fourth and Fifth years last week.

What is deflation?
The dreaded “D” word, one of the most feared economic blights, refers to sustained falls in prices in the economy for goods and services.

Don't we already have falling prices for some products?
Yes. For goods such as many types of clothing, Britain has got used to steadily cheaper prices as a result of intense high street competition and cheap imports from Asia. But deflation is different, meaning falls in prices more or less across the board.

But that sounds good. What's the problem?
The trend can sound like a money-saving bonanza. A short-lived burst of deflation for only a few months might end up like that and need not be a disaster. Problems start when consumers collectively curb spending, constantly waiting for ever-cheaper prices. In turn, this sucks the lifeblood of demand from the economy. With spending falling sharply, businesses sell less and less and are forced to cut wages and lay off staff - leading to even less spending, lower demand and sharper falls in prices. A vicious, downward spiral takes hold that can spell deep and prolonged recession. Once deflation sets in, it can be tough to reverse it, as negative effects feed on themselves. For example, if interest rates have been cut sharply to try to rekindle spending, then once they fall to zero it is impossible to cut them further and, after factoring in falling prices, this means that real interest rates are still higher than zero.

Are there any other effects?
Unfortunately, yes. Debt is a headache. Where prices and incomes generally are falling in a bout of deflation, this means that the real value of peoples' debts, relative to falling incomes, is rising. So debts become an ever bigger burden, stretching the time that is needed to pay them off to longer periods. This is known as “debt deflation”. In an economy such as Britain's, where households have the highest burden of debt of any leading economy, it poses a particularly severe danger.

How can economies escape?
With great difficulty. Deflation is like quicksand. Once in it, it is very hard to escape the mire. Solutions to “reflate” the economy are found in flooding the financial system with ultra-cheap money. This can be done by governments printing money to give away in tax cuts, although this risks irreversible damage to a country's finances, or by a central bank buying up assets from banks, effectively handing them extremely cheap cash.

Is deflation likely to take hold now?
There is a significant danger. Headline inflation in the United States could turn negative as soon as this week, after a huge reversal of last year's surge in fuel prices. In Britain, the Bank has said that it expects inflation on some measures to fall into negative territory for at least a few months. This may fall short of full-blown deflation, but will magnify the danger of it.

www.bankofengland.co.uk/education/targettwopointzero www.timesonline.co.uk/targettwopointzero

What is 'Quantitative Easing'?

Most nations are now reducing interest rates at a phenomenal rate to stimulate their economies and counteract a recession they are either in or are sliding towards. But what will happen if/when rates reaches 0%? What will they do then? One option is to actually break through the zero percent barrier and introduce a negative interest rate - which would basically be a tax on bank deposits. Perhaps savers would withdraw their deposits and spend them, however, it is probably more likely savers would withdraw the deposits and hoard their cash at home - thus reducing banks' liquidity. To counteract this, banknotes may even end up having 'best before dates' printed on them after which time they are deemed worthless! Thus forcing people to spend.

A different option which could be used to maintain interest rates at 0% is 'quantitative easing'. It is a monetary policy tool, which means the central bank prints new money, in order to increase the money supply. 'Quantitative' refers to the money supply; 'easing' essentially means increasing. So, the central bank floods the market with cash in an attempt to stimulate an economy in recession and, importantly for 2009, to stave off deflation. The idea is that if the central bank floods enough cash into the market, it will set off the following chain of events:

1. Banks and other financial institutions will build up larger and larger cash reserves.

2. Banks will finally decide to loosen their lending standards to utilize their excess cash.

3. Individuals and companies will start getting the loans they are seeking.

4. The economy will begin to recover as people and companies begin to spend again.

Quantitative easing was used notably by the Bank of Japan to fight domestic deflation in the early 2000s after its property and stock bubble bursts. It was a groundbreaking experiment and took a long time to work because the Bank of Japan was slow to employ all of its policy options and spell out its goals in a credible fashion. In recent weeks, both Ben Bernanke, Chairman, the US Federal Reserve, and British PM, Gordon Brown, have hinted at employing different monetary policies in the near futre for their respective economies. However, it should be noted, despite the almost certainty now that many Western economies will face deflation next year, the inherent danger of flooding the economy with cash can be very high inflation in the longer term. In fact, 95% of all historic cases of hyperinflation begin during either a deflationary depression or deep deflationary recession. (The other 5% is brought about by political stupidity as in Zimbabwe).

The dangers of deflation

Ireland and most western economies will find itself dealing with the problem of deflation next year. It is widely believed inflation will tumble during 2009 as oil and energy costs drop. Collapsing demand is symptomatic of poor business conditions. Those who anticipate deflation see it occurring because of people losing their jobs, and a continuation of the recession that we've been having. It occurs when the economy is in deep trouble. Irish inflation could even turn negative for the first time since 1946!

Shoppers coping with the increased inflation of late could be forgiven for welcoming the potential boost to the euro in their pocket, but they may not be so keen on the prospect of falling wages while saddled with the burden of debts piled up in the good times. The one silver lining for homeowners with inflation was that the value of their big debts such as mortgages was eaten away more quickly. With deflation the opposite is the case. A prolonged bout can lead to businesses and consumers deferring spending amid expectations that prices fall further still.

Deflation is far more difficult to control than inflation, unfolds at a faster rate and leaves more havoc in its wake. So what are the consequences of deflation?

• Along with deflation we get a contracting economy and badly run businesses will fail as will others that use old methods and technology.
  
• Business activity will decline, resulting in lower sales and profits, and many companies will declare losses.
  
• Commercial property will fall in price due to lack of demand and lack of credit.
  
• House prices will continue to fall and housing turnover will continue to remain low. This will be due to people seeing houses as a place to live, rather than an 'inflation hedge' or investment.
  
• Rising unemployment and the possibility of lower pay levels will also hit house prices.
  
• Commodities will fall in price, particularly base metals, as the production of goods that contain them will drop.
  
• The price of antiques and works of art could fall dramatically as the contraction in the economy and the difficulty in obtaining credit would make this market come to a virtual standstill.
  
• Benefit payments such as the state pension are also pegged to the cost of living. A period of deflation next year could herald much smaller increases for many people.