Strategy & economics

The naughty step

19/01/2015

Richard Jeffrey

Richard Jeffrey

Chief Economist

It is the new bogeyman; what governments are threatened with, if they are naughty: be good, or deflation will get you. And, it seems, some governments are not heeding the warning, because we are constantly being told that industrial economies are drifting into deflation. But the truth is more complex. In some economies, there are deflationary tendencies, but in others the low inflation rates that are being published are more a reflection of dis-inflation. So, what is the difference? Whereas I would regard deflation as a syndrome, disinflation is a characteristic.

The US and UK, amongst other economies, have seen inflation decline sharply over recent months. This is largely the consequence of the decline in the oil price, alongside the lesser impact of falling food prices. This fall in prices is taking place against the backdrop of generally robust growth, strong labour markets and early evidence that labour costs are beginning to rise more rapidly. Is this a deflationary environment? – very definitely not. I have heard some economists argue that consumers will delay expenditure because they expect declining prices to become more widespread and prolonged. However, there is very little evidence for this. Looking at the UK, there are numerous areas of consumer spending where prices have been falling for extended periods but real spending has increased – for example footwear. This year has seen prices of household appliances decline, but spending has been strong. Similarly prices of cars fell in 2013, but purchases rose sharply. That is not to say that consumers will never delay spending if they expect prices to fall – but the extent of an expected decline almost certainly has to be substantial before it brings about this type of behaviour.

In fact, for the US and UK, falling food and fuel prices have helped boost household spending, and will continue to do so in the near term. To the extent that these trends are the consequence of global supply and demand relationships (i.e. they are exogenous), they are having a similar impact on consumers as a tax cut. And, of course, core inflation, excluding these specific areas, remains in positive territory (in the UK, it rose slightly in December to 1.3% from 1.2% in November). Another indication that many of the downwards influences on prices in the UK are coming from outside the economy is provided by a comparison of inflation rates for goods and services. Whereas goods prices were down 1.0%, year-on-year, in December, services prices were up 2.3%. This contrast is important, since it suggests that domestically-generated inflation is somewhat higher than the headline CPI numbers might imply. Previously, we saw a similar contrast in the years of this century prior to 2006 – at which point, an increase in overall inflationary pressure took the authorities somewhat by surprise.

But elsewhere, deflation is a more real threat. Deflationary tendencies have been displayed in Japan for some considerable period, and they are now becoming increasingly evident in the eurozone. I referred above to deflation being a syndrome. What I mean by this is that it is characterised by a range of linked and economically very debilitating features. The key characteristics of deflation tend to be falling spending power and/or a declining propensity to consume. I believe we may currently be seeing both in some parts of the eurozone. A decline in real household disposable income reflects the underlying weakness of economies and labour markets in countries such as Italy, brought about by high debt levels and the impact on competitiveness of being in a single currency area. The key to maintaining competitiveness in countries that have poorer productivity than in, most obviously, Germany is to reduce labour costs. But this can lead to a downward spiral in demand, output, employment, and wages. On top of this, a characteristic that is similar in Italy, some other countries in the eurozone and also Japan is that they have ageing populations. This can also be deflationary, because older cohorts in the population tend to have a lower propensity to consume.

If there is no major structural reform within the eurozone, deflationary tendencies will tend to persist, and will likely lead to growth remaining sub-optimal. Moreover, it is unlikely that such tendencies will be reversed by quantitative easing (at least, not on the scale being discussed). At the same time, it is important that we do not confuse an ongoing predisposition towards deflation with the more helpful disinflationary trends that are being experienced in countries such as the UK and US. To do so would be likely to result in policy mistakes being made.

This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. 

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