Sunday, January 18, 2015
How to prevent good deflation turning bad
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.

How unusual is deflation? The Office for National Statistics has an inflation measure which goes back to 1800, mainly based on the retail prices index (RPI). In nearly 70 of those years, prices fell -Britain experienced deflation - though the closer you get to today, the rarer the phenomenon is.

So in the 19th century, slightly more than half the years, 52, had annual deflation. This dropped to 15 out of 50 in the first half of the 20th century, including much of the 1920s and the early 1930s. From 1950 onwards, however, deflation has been very unusual. In only one year, 2009, did prices fall on the ONS’s measure, by 0.5%, and this only because it was distorted by the very sharp reductions in interest rates. Other measures showed modest inflation even in the depths of the crisis.

To add a bit more historical perspective, prices at the end of the 19th century were 34% lower than that at the start. Some of that reflected developments in commodity prices, but much of it reflected technical progress and lower prices for industrial products.

The story of the 20th century was very different. Prices at the end were 73 times those at the start, 72,000% higher. Most of that occurred in the second half. While prices in 1950 were 3.5 times their level in 1900, in 2000 they were 20 times their 1950 level. Most of us have only known inflation, and often very high inflation.

Did the deflation of the 19th century inhibit economic growth? I only have numbers going back to 1830 – the Bank of England’s “three centuries of data” series - but they show that real gross domestic product in 1900 was more than four times its level 70 years earlier. Mostly it was good deflation.

I write this because, as everybody will have noticed, Britain’s inflation rate fell to just 0.5% last month. On this measure, based on the consumer prices index which is not directly influenced by interest rate changes, inflation in 25 years has only been this low once, in May 2000. Nobody took any notice of this particular measure back then. Only when it became the Bank of England’s target measure a few years later did we pay attention.

It seems certain that records will be broken in the coming months. Petrol and diesel prices have further to fall, as do household energy bills. Inflation should fall to zero, and may even temporarily dip below it. It is unlikely that we will get deflation for the year as a whole, but perfectly possible that inflation this year will be the lowest in more than a quarter of a century. To do that it needs to get below 2000’s annual inflation, which was 0.8%.

We will never again see the wild harvest-related swings from inflation into deflation we saw in the 19th century – one year prices could be up 12%, the next down 23% - but there is an echo of that in what is happening now. At a time of low inflation, big swings in commodity prices can tip economies from a modest rise in the price level into deflation.

A few weeks ago I wrote here about “good” and “bad” deflation, a distinction which many have taken up. Good deflation arises from a favourable international price shock, the kind we are seeing with the sharp fall in the price of oil and other commodities. Bad deflation arises from weak demand.

Back in 2000 Britain was also benefiting from “good” influences, which bore down on inflation, most notably the so-called China effect which reduced the prices of manufactured goods, even while service-sector inflation remained quite high.

Today, as then, Britain does not have deflation, and may not do so, but it has “good” low inflation, again mainly arising from international influences. The EY Item Club, in a forecast to be published tomorrow, says that inflation will average close to zero this year and by boosting real disposable incomes – it predicts a very strong rise of 3.7% this year – the fall in inflation will help deliver growth of close to 3%; 2.9%. It is, it says, a timely boost, given that the economy was losing some momentum at the end of last year.

I agree with that. The right way to view the drop in oil prices is as the equivalent of a tax cut. “It will provide a major boost to disposable incomes and consumption in 2015 and help stay the hand of the MPC (monetary policy committee) on interest rates,” says Item. “It should also stimulate our European and American export markets and support business confidence and investment.”

Is there a risk that good deflation, or good low inflation, could turn bad? As one who wrote some years ago that the sustainable price of oil was closer to $40 a barrel than $100 or $150, I have an interest in the current low price. But there is a danger that for oil and other commodities, the fall becomes a rout. In some respects it already has, hitting the stock market. If oil falls too far now, it guarantees that it will be higher later, because exploration and development will be cut back sharply.

There is also a risk that those who benefit from falling oil prices and very low inflation do not use it. In microcosm in Britain, we now have BP cutting back and it and other North Sea producers crying out for help, while most non-oil businesses are in rude health, official figures showing that their profitability in the third quarter of last year was the highest for 16 years. But if they sit on that cash rather than invest it, the benefit will be lost.

Similarly, if employers were to use the opportunity of zero inflation to drive down pay increases, the real income boost to demand would be muted, if not lost, a point taken up by David Cameron on his trip to Washington.

What is true of Britain is also true globally. The World Bank does not usually cause much excitement with its economic forecasts but its downgrading of global growth prospects did sent a frisson through the markets. It still expects world growth to accelerate this year, from 2.6% in 2014 to 3%, but not as much as it did. It made the point that the beneficiaries of lower oil prices – most countries – use those benefits to more than offset cutbacks by the oil producers.

John Llewellyn of Llewellyn Consulting makes a similar point, and warns of the danger that while the first effects of the falling oil price are to boost consumer spending in the West, the second will be to hit exports to countries hurt by it.

Those effects must be counteracted, in Britain and elsewhere. In Europe it means building on the benefits of the lower oil price with some aggressive quantitative easing. We must not look this gift horse in the mouth.