Going up or going down
The Consumer Price Index is a key indicator used by the Bank of England to decide the level it sets interest rates at. Business Month asked two local economists what the risks of inflation or deflation are likely to be...
Richard Ramsey,Chief economist Ulster Bank
Excuse the pun, but the idea of discussing inflation might not swell many people’s enthusiasm. However, this seemingly dry subject looms large over the economy, as the rate at which prices are rising or falling can have huge implications for consumers, businesses and even countries.
Indeed, inflationary/deflationary events are etched in the consciousness of three of the four largest global economies — the US (The Great Depression), Japan (The Lost Decade) and Germany (hyper-inflation in the Weimer period).
In terms of inflation, ‘anoraks’ will be pleased that Adam Fergusson’s iconic inflationary text When Money Dies has been republished. The book may sound like the title of a James Bond film, but it chronicles Germany’s hyper-inflation during the 1920s. This inflationary period was so extreme, and its human impact so severe, that it is viewed as a |financial horror story. The monthly inflation rate hit 29,500% in October 1923, which was equivalent to prices doubling every four days.
When Money Dies illustrates the phenomenon of exchange rates being altered several times a day. Nipping out to the corner shop for a loaf of bread would require loading up the wheelbarrow with cash. At restaurants, meals would cost more when the bill arrived than when the food was ordered. Clearly, such an inflationary environment would have people fighting to buy the first round in the pub!
However, you do not need hyper-inflation (defined as exceeding 50% per month) for |inflation to be a problem. The UK’s official inflationary history has been much tamer than Germany’s hyper-inflation. Nevertheless, inflation wreaked havoc on the UK economy in the 1970s and 1980s. Using the
Retail Price Index (RPI) measure, the monthly inflation rate peaked at 4.3% in July 1979 while the highest annual inflation rate recorded was 26.9% in August 1975.
The UK economy has not experienced double-digit annual inflation since October 1990, but even single-digit inflation rates can cause a problem. This was highlighted at the UK’s most recent inflationary peak of 5.2% y/y in December 2008. Since then, the Bank of England (BoE) slashed interest rates to a 315-year low and embarked on the process of quantitative easing (QE), as deflationary fears moved centre-stage.
Thus far, deflationary fears, at an economy level have failed to materialise, with inflation consistently coming in higher than expected. Indeed, in the 37 months since the credit crunch began, Consumer Price Index (CPI) inflation has remained above the 2% year-on-year Monetary Policy Committee (MPC) target on 30 occasions, and currently stands at 3.1% year-on-year. There are risks that this track-record of overshooting will feed into consumers’ expectations, which in turn may become self-fulfilling. The October MPC minutes highlighted a three-way split over whether interest rates should be raised, or whether an additional round of QE should be released. Essentially, this highlights the fine balance between the prevailing inflationary and deflationary risks.
Even if further QE takes place to ward off deflationary forces, it would be misguided to think that inflation is not a problem. Already it has been claimed by some commentators that the Federal Reserve’s QE to date has fuelled inflationary pressures in Asia and commodities markets.
Gold is a natural inflation hedge and its recent record price level indicates market concerns over future inflation.
The MPC is focused on inflation at the economy level. However, the impact of inflation — even low rates of inflation — can still be a problem. Inflation and its impact depends on your
individual circumstances and what sector of the economy you are in. Even a very small rate of input cost inflation can be |extremely damaging for a firm if lack of demand leads to falling output prices.
This has been a problem for Northern Ireland firms, which, according to the monthly PMI (Purchasing Managers Index) surveys, have reported output price deflation and a profit squeeze for two years.
Furthermore, in the context of pay and benefits freezes, any rate of inflation erodes one’s standard of living.
A major inflationary threat is the ongoing surge in commodity price inflation, particularly agricultural products, which have surged by 55% since June 2010.
This is expected to feed through into food price inflation in the coming months, at a time when food inflation is already running at more than 5% year-on-year.
Lower-income households who spend a disproportionate share of their income on food will be hardest hit.
Meanwhile, the surge in cotton prices is a threat for the retail industry with VAT to be hiked to 20%, and ‘fashionistas’ facing rising costs for their threads.
Back in September, the annual inflation rate of clothing and footwear reached 9.4% (RPI), its highest rate since June 1980.
Finally, inflation-busting tax rises at the local level, such as rates and the introduction of water charges, are just around the corner. Clearly, inflation remains a threat to the economy.
Head of economics at Bank of Ireland
As we edge closer to 2011, how real is the risk of deflation to the local economy? At one level, it seems a rather esoteric question since there is a world of difference between a situation where prices are rising more slowly or not rising at all, and one where the general price level is actually falling (deflation). The latter, so typical of much of the 19th century and early part of the 20th century in Britain (and more recently, Japan), is to be avoided, if at all possible, particularly when debt levels are high.
It is also important to distinguish between input price inflation (cost of raw materials etc), output or factory-gate inflation and the most common measure, consumer or retail price inflation. They may not all be moving in the same direction simultaneously.
A sustained spell of deflation with falling prices, falling asset values and falling incomes across the economy would turn an already difficult economic situation into something much more challenging.
One of the features of the 2008-2010 financial crisis has been a renaissance in Keynesian concepts of the “paradox of thrift” and “liquidity trap” — the notion that interest rates could be reduced to zero (or almost zero) without having the desired stimulative effect on the economy.
For Keynes, the analogy was one of pushing on a piece of string as the normal transmission mechanism from lower |interest rates would be impaired. Instead of encouraging borrowing, spending and investment, the established order would be one of increased savings, accelerated debt repayment and, in the extreme, cash hoarding.
Some might argue that this has indeed been the picture for the UK during 2009 and 2010, forcing the Bank of England to reach for the less conventional policy ‘tool’ of Quantitative Easing (QE).
Looking ahead, I have little doubt the experience of a number of local households and firms during 2011 will be one of deflation. It may not show up in any official figures — indeed, we do not have regional price indices that would provide some definitive measurement – but it will certainly feel like it.
Particularly susceptible will be those parts of the economy that are dependent on consumer and government spending and those focused entirely on a domestic market that has diminished in size by over 5% from peak in 2007.
Evidence of what economists call an ‘output gap’ or more simply understood as ‘spare’ or ‘overcapacity’ is now evident in a number of activities including tumbling hotel room rates, below-cost tenders from contractors seeking public and |private-sector work and the greater commoditisation of professional fees and chargeable rates. In many areas, it is now a |buyers’ market and price competition is intense.
For many households, the picture will be more mixed and possibly confusing over the next 12-18 months. While some will be experiencing continued pay restraint, stagnant incomes and house values that could slip further, the reality is that many of the inflationary “impulses” emanate from indirect taxes — VAT is scheduled to rise to 20% in January — and developments in international markets for oil, gas, food and other commodities where there is also sensitivity to the exchange rate.
Lately, we have seen annual food price inflation running at more than 5%, reflecting a surge in wheat prices while a jump in cotton prices to a 15-year high has fed through to some pick-up in clothes prices in the shops. Oil prices have been less volatile in recent months but with a vulnerability to supply “shocks” and global recovery-led demand.
Service sector prices are also likely to be more stubborn in the year ahead — a breakdown of the components of CPI last month revealed areas such as transport, communication and education showing annual inflation of between 4.4 and 6.4%. Furthermore, as the squeeze comes on Northern Ireland’s public sector, we are likely to see costs and charges rising (or introduced) for some of the services we avail of.
The Bank of England has tolerated a sustained period of consumer price inflation running above target, on average by about 1% since the crisis began in mid-2007. Forecasts for a return to target have been consistently over-optimistic and rather than 2.0% being the central point of a symmetrical target, it has in practice become a ‘floor’ for a new, unspoken and broader measure that attaches greater weight to growth, credit, asset prices and financial risks. Such a pragmatic approach has seemed appropriate for the fragile conditions.
The current policy bias does seem to be drifting towards more QE, a sign that the risks of deflation are perceived as outweighing the risks to inflation in the medium term, looking beyond the one-off influences such as VAT increases.
However, the immediate risks of a period of general deflation are very low in my view. For some of us, it will feel like we are in such a phase but the numbers will be telling us something else. At the consumer/retail level, expect “price stickiness” to remain a feature during 2011 with the most likely outcome being a gradual slowdown in the rate of inflation. 2012 may be a different story, when the rate of inflation may look uncomfortably low.