Sunday, February 15, 2015
'Good' deflation boosts growth - will it bring forward rate rises?
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.

It is easy to get depressed about deflation. Deflation and depression are linked in the mind for good reason. In what economic historians call the first great depression, which lasted from 1873 to 1896, prices fell by a fifth. In the more familiar second great depression, in the 1930s, prices in 1934 were 12% lower than in 1928.

So why, when these gloomy associations are so powerful, has the Bank of England’s response to the prospect of deflation in Britain in the coming months been something close to hanging out the bunting?

Mark Carney, the first Bank governor to predict deflation (though he prefers to call it “temporarily negative inflation”) since Montagu Norman in the inter-war years – and back then the Bank did not do anything so vulgar as issuing a public forecast – was positively upbeat about the “stronger underlying dynamics” affecting the British economy.

The halving of oil prices over the past six months, the main factor pushing inflation towards negative territory is “unambiguously positive” for the global economy, he said. It is also, according to the Bank, manna from heaven for Britain.

Three months ago it expected real post-tax household incomes to rise by just 1.25% this year. Now it expects a 3.5% increase, which Carney reminded us will be the best for a decade. The difference, by the way, is equivalent to a boost to spending power of roughly £25bn.

Some of this will be familiar territory to those of you who have followed my recent pieces on this theme. This, the Bank is saying, is “good” deflation with knobs on, a gift from America’s frackers and the Organisation of Petroleum Exporting Countries to every oil-consuming economy, including Britain.

It is a very far cry from the “bad” deflation of the late 19th century and the 1930s, when falling prices were the product of economic weakness. Bad deflation which becomes entrenched is dangerous for many reasons, not least because the real burden of debt increases, which further hampers growth. A vicious cycle of stagnation and deflation can develop.

The surprise about the Bank’s “good deflation” assessment is not that it is upbeat but that it is quite so upbeat. Britain will enjoy three more years of overall economic growth of close to 3% (2.9% 2015, 2.9% 2016, 2.7% 2017), driven by strongly rising consumer spending but also robust business investment.

Consumer spending will grow at 3.75% this year and 3.5% next, without a meaningful drop in the saving ratio. Households will be spending out of their strongly rising real incomes, with inflation close to zero for most of this year, and set to drop below zero for a month or two in the spring.

Unemployment will continue to fall. Export growth will outstrip that of imports this year. The members of the monetary policy committee (MPC), far from reading from the depression script, are overcome with optimism. Economic spring has sprung early. Had the Treasury produced such a forecast less than three months before a general election, it would have been accused of producing politically-driven predictions. The independent Bank is, of course, above such things.

There are two questions about this. One is whether the Bank may have overdone the optimism, and is at risk of overdosing on happy pills. The other is whether the net effect of a bout of temporary deflation will end up bringing forward the first hike in interest rates.

Is the Bank over optimistic? In its last published minutes, some MPC members fretted about the response of employers to an inflation rate that will fluctuate either side of zero in the coming months. If workers are experiencing no inflation, or a month or two when prices are lower than a year earlier, why award pay increases? Could pay settlements follow inflation down, notwithstanding David Cameron’s plea to firms to boost wages?

The risk is there but the Bank’s central forecast has chosen to ignore it. Currently, average earnings are rising by less than 2%. This year, it predicts, they will accelerate to a 3.5% growth rate – more than it expected three months ago – rising further to 4% in each of the following two years. Such increases, which imply real wage increases running well ahead of productivity, are central to the Bank’s upbeat forecast.

I don’t think there will be an outbreak of pay freezes as a result of the zero inflation/deflation in coming months. If there was it would elevate the risk of prolonged deflation. But it also looks a bit of a stretch that in this environment earnings will soon be rising at double their current rate. The mechanism is that a tightening labour market – falling unemployment – will leave employers with little option but to be more generous on pay. But it is a big uncertainty.

The other is whether the impact of cheap oil on the global economy will be quite so unambiguously good. There is no doubt that it will be beneficial. The question is whether it is beneficial enough to offset other dampening factors, including the continuing uncertainties in the eurozone.

To take my second question, and assuming the Bank is right to be so upbeat, could this bout of temporary deflation bring us closer to the first interest rate hike since 2007, and the first move in any direction since 2009? Some of the headlines generated by the Bank’s inflation report suggested that it was ready to cut interest rates further and unleash another bout of quantitative easing if the temporary dip into deflation proves to be more enduring.

Though that is true, it is not the message the Bank wanted to convey. It thinks its main response on those circumstances would be to keep interest rates at 0.5% for longer.

The broader message was that this year’s zero/negative inflation will pave the way, not only for stronger growth now but for higher inflation and interest rates later, as that stronger growth feeds through to higher prices. Though this was the first inflation report to allow for the possibility of deflation, it was also the first in a long time to suggest that inflation in just over two years will be above the official 2% target.

That does not mean the MPC is going to shock us with sudden and dramatic interest rate hikes; “gradual and limited” are still the watchwords. It does mean, on this forecast at least, that by the time Carney leaves the Bank in the summer of 2018, he expects to have a few rate hikes under his belt.