Sunday, December 21, 2014
Don't be too afraid of the big bad wolf of deflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

A few days ago something happened which I have not experienced for a very long time, if ever. Inflation fell to just 1% and will surely go even lower when the figures for December are published next month.

This will mean that Mark Carney will be obliged to write an open letter to George Osborne to explain why inflation has deviated by more an a percentage point from the 2% target. This will also be, for now at least, a unique occasion.

There have been 14 such Bank of England governor letters since Gordon Brown announced Bank independence in 1997. All of them were written by (Lord) Mervyn King, and all of them were to explain an inflation overshoot; a rate of more than 3%. This will be the first undershoot letter and, while Bank governors are meant to be neutral on these things, Carney wouldn’t be human if, with interest rates already at record lows, he will find this one easier to write.

Why is 1% so unusual? After all, the Office for National Statistics said last week that this was merely the lowest rate of consumer price inflation for 12 years. Twelve years ago, however, we did not know much about the consumer prices index. It was promoted by Brown in 2003 – and became the Bank’s target – ostensibly to make it easier for Britain to join the euro, which may surprise you. This was because, as a “harmonised” inflation measure, it was used by other countries in Europe.

In the early 2000s, we still used the retail prices index, and its close relative, the retail prices index excluding mortgage interest payments (RPIX). Both fell very sharply in the crisis in 2009, but by that time we had moved on. Until then the RPIX measure had never been as low as 1% and you had to9 go back to 1960 for the last time RPI inflation was 1%. Even I wasn’t following these things closely then.

The great inflation that followed means that prices now are 21 times what they were in 1960. For most of the past half century or so, a 1% inflation rate would have seemed like a fantasy.

If there is a rule about these things, it is that as soon as inflation falls to low levels, people start screaming about deflation; a sustained fall in prices. Thanks to one silly comparison, we are supposed to be heading for the lowest public spending since the 1930s. It is not a giant leap, for some, to imagine that we are heading for the deflation of that decade.

People should calm down, for three reasons. The first is that, while it is possible if oil prices were to collapse to, say, $40 a barrel, inflation could go negative, it is unlikely to stay negative. Even in the highly uncertain conditions of 2009, a sharp fall in oil and commodity prices passed through only into temporarily low inflation. What economists call “base effects” – you can only benefit from a one-off price shock once – are likely to push inflation higher as we move into the latter part of 2015.

Second, it is very clear where the downward pressure on prices is coming from. Food and non-alcoholic drinks were 1.7% lower last month than a year earlier, reflecting lower commodity prices and supermarket competition. Fuels and lubricants for cars were 5.9% lower, as a result of the drop in world oil prices, with more to come.

There has also been a drop in so-called core inflation, excluding food, energy, alcohol. But, even more than the consumer prices index, it is unlikely to go negative for any sustained period of time.

A better measure of domestically-generated inflation is service-sector inflation. Last month this was running at 2.4%. In June it was 2.5%. This does not point to an economy sliding into deflation.

The final point is to elaborate on what I wrote last week about the eurozone, and the idea of good and bad deflation. Bad deflation is that which results from chronically weak demand. Nobody could pin that on Britain. In November, helped by Black Friday madness, we bought 6.4% more goods than a year earlier. Exclude petrol and diesel and the rise was an even more heady 6.9%.

We will have to wait to see whether there is some payback this month, but these were boom-like numbers of Klondike proportions, the best for more than decade.

Good deflation, by contrast, is when prices fall because of a beneficial price shock. The plunge in oil prices and the weakness of commodity prices is delivering a gift to the economy that we should seize with both hands. Good deflation is good news.

We can see that with the latest average earnings figures. Though these were not strong – more of an uplift might have been expected with the 3% rise in the national minimum wage in October – the growth in regular pay of 1.6% and in total pay of 1.4% in the latest three months compared with a year earlier is outstripping inflation.

The details of the numbers suggest there is more of this to come. Since the spring, regular pay has been rising at an annualised rate of more than 3%.

The Bank’s monetary policy committee noted this in its latest monthly minutes, published on Wednesday, which maintained the 7-2 split on interest rates, with the same two members, Martin Weale and Ian McCafferty, continuing to vote for a quarter-point rate hike.

For the rest, the prospect of what it described as a “significant period” ahead of below-target inflation, one senses that they will take some shifting. The pick-up in pay, which is “promising”, will have to go a lot further even to be consistent with the 2% inflation target.

It may be that the Bank will hike rates, late next year, even when inflation is running below target, if it believes that the only way is then up. But that will be a challenge. After what will then be more than six years of a record low 0.5% rate, the Bank might be accused of responding to phantom fears.

Weale and McCafferty argue that the Bank should “look through” the current weakness of inflation, just as it looked through earlier post-crisis overshoots. But the Bank will want to be sure of tis ground. Low inflation pushes out the timing of the first hike. This time next year we may still not have seen a move.