Sunday, May 24, 2015
A little bit of deflation does you good
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.

Britain’s drop into deflation has produced a mix of curiosity, celebration and, in some quarters, alarm. The fact that the consumer prices index (CPI) last month was 0.1% lower than a year earlier (as distinct from unchanged in February and March) is of little practical significance.

But it has certainly provoked a lot of curiosity. Though the CPI was not even a twinkle in the statisticians’ eyes in 1960 – back then inflation was measured by the retail prices index – the Office for National Statistics (ONS) has managed to “backcast” the data to then. So we have been treated to comparisons which show this is the first episode of CPI deflation since Princess Margaret married the future Lord Snowdon, the skiffle artist Lonnie Donegan topped the charts and Wolverhampton Wanderers last won the FA Cup.

If the current deflation episode is as short-lived as many believe, it is a slightly sobering thought that in 55 years’ time somebody could be looking back and running comparisons to the quaintness of life in 2015, and which tunes we were all whistling from the charts. I should probably add a "not" there.

Mostly, the reaction to the drop into mild deflation has been to celebrate it. This has to be right. When I wrote about “good” deflation last year, I think I was one of the first, if not the first in this episode, to do so.

Good deflation in when prices fall in response to a favourable global price shock, in this case a sharp fall in oil prices. Bad deflation is when prices are dragged down by a lack of demand in the economy and is associated with stagnation.

Though the supermarkets might argue there are elements of bad deflation in the current picture – they are fighting like cat and dog for the consumer pound – it is overwhelmingly good. Mark Carney, the Bank of England governor, says that we should enjoy it while we can and he is right. An oil glut has delivered a welcome boost to household incomes and energy-using businesses. Good indeed.

For evidence of good deflation, look no further than the latest retail sales figures, which showed a 1.2% increase in spending volumes last month, for a rise of 4.7% up on a year earlier. A 3.2% drop over 12 months in what the ONS calls shop prices, but in practice was largely driven by a big fall in petrol prices, was a big reason for what is a mini consumer boom.

Some, of course, will always look a gift horse in the mouth and worry that we are about to return to the 1930s, though there was less of this this time than I might have feared.

But the fact that inflation is temporarily sub-zero, and will fluctuate around this rate for the next few months, raises an interesting question; one I have been asked a lot over the past few days. If inflation at close to zero is such good news why do we not make zero the permanent aim? Why do politicians and central bankers talk about price stability and then adopt a 2% inflation target? After all, after 20 years of 2% inflation, prices at the end would be nearly 50% higher than at the start.

Governments do not go for zero inflation targets for a variety of well-known reasons. Sometimes, as often over the past six years, they want a negative real (inflation-adjusted) interest rate, in other words an interest rate that is lower than the inflation rate, to boost the economy. If zero is the target and the norm, the only way that can be achieved is through negative actual interest rates, which are not generally to be recommended.

Aiming for zero would also run the risk of prolonged periods of deflation. At any time there would be an equal risk of inflation being negative and positive. Given the wayward inflation forecasting record of the Bank since the crisis, overshoots into deflationary territory could be prolonged. That would bring into play some of the dangers economists tend to emphasise about deflation, notably the fear that households and businesses will delay purchases until prices are lower. Deflation also raises the real value of debt; not something you want when you have a lot of it.

Because of these and other effects, economists caution against aiming for zero inflation. Almost 20 years ago a group of economists led by George Akerlof, did research for the Washington-based Brookings Institution, and calculated that a zero inflation target would lead to a permanent loss of gross domestic product and jobs of 1% to 3%. The big reason they cited was that zero inflation makes it hard for wages in different parts of the economy to adjust; pay cuts can be as awkward as negative interest rates. Real wages end up too high, and employment too low. Akerlof, as well as being a Nobel laureate, is the husband of Janet Yellen, chairman of America’s Federal Reserve Board.

In all likelihood this period of “noflation”/mild deflation will be short-lived. A one-off price shock will drop out of the inflation comparison by the end of the year. The last time we were briefly negative, all those years ago, inflation rose quite sharply afterwards.

There is a possibility, however, that very low inflation becomes entrenched. Fathom Consulting points out that core inflation, excluding energy, food, alcohol and tobacco, is at a record low of 0.8% and falling. Service sector inflation, which normally outstrips overall inflation, has come down to 2%.

Meanwhile, so-called pipeline inflation pressures are very low. “Factory gate” prices for manufactured goods last month were 1.7% down on a year earlier, or zero excluding energy and food. Raw material and fuel prices, down 11.7%, are still reflecting sharp oil and commodity price falls.

It may be, as noted last week, that rising wage pressures compensate for some of these deflationary impulses, though one of the reasons why both the Treasury and the Bank are keen to emphasise the temporary nature of the current episode is that they do not want employers to respond to zero inflation with zero pay rises.

One thing is reasonably clear. We are now in a prolonged period – 16 months so far – in which inflation has been below the 2% target. It pre-dated the sharp fall in oil prices. It was preceded by 48 months in which inflation was above the target, exceeding 5% at times.

If that tells you we should be sceptical of the ability of central banks to keep inflation on target, whether that target is 2% or zero, it is a good lesson to draw. If it tells you we should expect big inflation swings in the coming years, in both directions, that is a good lesson too.