Sunday, March 29, 2015
Don't forget asset prices. Cutting rates is not the right response to zero inflation
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 big fat zero. No inflation at all. Though it is not guaranteed, a run of deflation – prices lower than a year earlier – seems highly likely in the next 2-3 months.

For many people this is uncharted territory. Though retail price inflation fell to zero in February 2009, and was negative for the following eight months, this reflected the sharp reductions in interest rates of the time. Inflation measured by the consumer prices index (CPI) remained positive throughout.

No, you have to go back 55 years, I suspect before many readers were born, for anything like this. The Office for National Statistics (ONS) has usefully modelled the current CPI back to January 1950. It shows that inflation last fell to zero in December 1959, and was negative by 0.5%-0.6% for three months.

Zero inflation is proving to be good news for the economy. Retail sales volumes rose by 0.7% last month and were a booming 5.7% up on a year earlier. As far as retailing is concerned, deflation is not merely on the way. It has been with us for some time.

So what the ONS describes as average store prices fell by 3.6% in the 12 months to February, a record. Stores include petrol stations, so much of this reflected the drop in fuel prices over the past year. But prices were also modestly lower for both food and non-food stores. Falling prices genuinely are putting money into people’s pockets.

At this point it is customary to warn that, while a temporary bout of deflation is a good thing, you would not want to make a habit of it. Indeed.

There are, however, a couple of other aspects to this. History rarely repeats itself but if we look at what happened when inflation last fell to zero and turned negative, it did not usher in prolonged deflation.

By the end of 1960, inflation was heading back up towards 2%. By the end of 1961 it was 4% and by the middle of 1962 it was 5.6%. The 1960s were not a particularly high inflation period, but even with a very low start, prices rose by an average of 3.4% a year over the decade.

Not only that, but it is easy to forget how recent this experience of ultra-low inflation is in Britain. After four years above the 2% official target, inflation only dropped below it at the beginning of last year. As recently as September 2011, Britain had an inflation rate of 5.2%, and as recently as last 2013, the country’s “natural” or normal inflation rate seemed to be 3% rather than 2%. It is far too early to say whether anything fundamental has changed.

The bigger danger is that this brush with deflation will take central bankers’ eyes off the ball. Before the crisis, the criticism was that the obsession with inflation targets allowed a toxic build-up of risk in the financial system and a huge rise in asset prices, particularly house prices but also financial assets.

There is a powerful echo of that today. At exactly the same moment the ONS released the latest inflation numbers a few days ago, it also published figures showing house prices up by 8.4% on a year earlier. Though this is slightly off the pace of last year, the juxtaposition neatly encapsulated the question I get asked very often: How can inflation be so low when house price are rising so fast? Housing, after all, is a significant component of most people’s expenditure.

Inflation measures do not deal particularly well with housing costs. But those that do incorporate housing, the ONS’s CPIH measure and the old retail prices index, while not showing zero inflation, have it very low; 0.3% and 1% respectively.

Nor is housing the only asset price which has been rising strongly. The stock market had a touch of the wobbles last week but is well up on its level of a year ago. Government bonds, gilts, show a 12-month rise of more than 15% on average.

The Bank of England would say some of this is deliberate. Keeping long-term interest rates low has been an aim of policy, and the counterpart to that is rising gilt prices. The housing market has been part of the recovery story, and a deliberate policy target, and a by-product of that is higher prices. Whether or not there is a government bond bubble remains to be seen but there is not a housing bubble yet, and the parts of London where there was the greatest risk of it has been gently deflating.

The risk, however, is that leaving interest rates too low for too long inflates new bubbles. Already the sharp drop in inflation has persuaded the two hawks on the Bank of England’s monetary policy committee (MPC), Martin Weale and Ian McCafferty, to drop for now their call for higher rates.

Mark Carney, the governor, having tried to pull the markets back from the view that rates were never going to go up, has in recent speeches pushed them out again, citing not only the threat from “persistent external deflationary forces” but also the pound’s rise against the euro. Andy Haldane, the Bank’s chief economist, reckons that “policy needs to stand ready to move of either foot”, and that in his view the next move in rates is as likely to be down as up.

That worries me. Kristin Forbes, another MPC member, rightly pointed out in a London Evening Standard article that most domestically-based measures of inflation are stable. Service-sector inflation, which is above 2%, has actually edged up in the past two months.

To be fair, Carney, along with Ben Broadbent, a deputy governor, made clear on Friday that they will not over-react to the drop in inflation, and that they expect the next move in rates to be up.

The one-off effects of the big fall in oil prices will drop out over the next 6-9 months, though second-round effects could last for a little longer. Even so, the right response for the Bank to either high or low oil prices is, to quote Rudyard Kipling, “to treat those two impostors just the same”.

That means preparing the ground for a gradual “normalization” of interest rates over the next 2-3 years, in other words slowly raising them starting later this year or early next, and forgetting talk of further cuts. After all, nobody would forgive the Bank for squandering the gift of low inflation it has been given, and repeating the experience of the early 1960s. And nobody would forgive it for allowing dangerous bubbles to inflate again. Inflation at zero is a happy accident, it should not be allowed at develop into an nasty accident.