Deflation: Should you be afraid?


Judging by recent headlines, the deflationary threat is the economic horror story de jour. However, while it may rival alien invaders or blood-sucking vampires in its capacity to breed fear, the evidence for an imminent attack is actually rather patchy.

Deflation should be defined carefully – it is not a one-off fall in prices but a sustained and generalised decline in the price level. The recent drop in consumer price indices across many major economies does highlight that price pressures in the global economy are weaker than historical averages. However, in most developed economies the current conditions are probably best characterised as ‘lowflation’, i.e. a sustained period of below target inflation. In the EM world, disinflationary forces are even scarcer still.

Of course, the credibility of the deflationary threat depends on whether one views the recent price dynamics as something of an early warning sign ahead of a more sustained period of falling prices. Here, we caution against the assumption that deflation is the obvious next step on from disinflation. It is true that some of the disinflationary forces impacting the global economy are capable of exerting downward pressure on global prices over the longer term. However, a closer examination of these factors suggests that they provide only a partial explanation at best of recent price dynamics.

Take for example the argument that technological changes have lowered the cost of producing goods and services. If this was true, one would expect productivity trends to improve noticeably as expensive excess labour was replaced with technology. However, this has not been the case. In the US, productivity growth remains relatively subdued with output per hour of US business sector workers far below its longer term average. Other structural factors such as a private and public sector debt deleveraging in the aftermath of the financial crisis may be having a more profound impact on real activity. Certainly, those economies that saw the greatest build up in debt between 2000 and 2008 have tended to see lower growth since the financial crisis. However, even here there are exceptions with Sweden and Australia noticeable examples.

To understand better the disinflationary trends it is worth looking more closely at cyclical forces. The most obvious of these is the recent fall in commodity and oil prices which appear to be driving an increasingly large wedge between headline and core inflation across many major economies (See Chart 1). Although the recent correction is unusual because it has not corresponded with a significant drop in global growth or a correction in asset prices, the impact of similar price correction in the past has led to temporary rather than sustained and generalised declines in prices.

Other cyclical forces may be contributing considerably to the lowflation environment, at least on a temporary basis. An examination of unemployment trends since the financial crisis suggests that deficient domestic demand has been the primary reason behind the persistent negative output gap experienced by the world’s major economies, rather than some intractable supply side blockages. In this environment, the typical policy prognosis would be fiscal and monetary stimulus.

However, the reality has been that fiscal and monetary policy has not been loose enough. Fiscal policy has been relatively tight in countries such as the UK and parts of Europe that suffered a large collapse in aggregate demand during the crisis. In terms of monetary policy, while the Fed, and more recently the Bank of Japan have employed their unconventional tools aggressively, policy has been far too tight in the Eurozone, as exemplified by real short-term interest rates that currently lie above those of the US (see Chart 2). This partly reflects a breakdown in the transmission mechanisms of monetary policy, though that too reflects policy mistakes in the wake of the crisis.

If these cyclical forces are having an over-sized influence on recent inflation trends then the outlook for prices going forward should very much be tied to whether the global economic recovery continues to gain traction. We would argue that in the US the signs are encouraging with a tightening labour market likely to underpin a recovery in wage growth, feeding through to higher greater domestic demand. If anything the decline in commodity and oil prices will serve to amplify this trend. If this steady improvement trend is maintained we can expect the Federal Reserve to cautiously begin to raise rates cautiously later this year.

Elsewhere, the challenges are more complex, with a more meaningful policy effort required. This is certainly the case in the Euro-zone where the ECB appears set to finally break out of the strait jacket placed upon it by sovereign member states; who have failed to agree on liability-sharing arrangements to go with their monetary union. A bond buying programme of €500 billion or more has been mooted as it looks to reverse the collapse in inflation and credit creation in the region. However, this is unlikely to be sufficient to push the economy decisively away from its current slump. To resolve its demand deficiency problems, governments should also commit to a more expansive fiscal plan, reversing the austerity measures that have hampered growth since the financial crisis, as well as launching more ambitious structural reforms.

While we recognise the challenges to Europe delivering a dual demand-side stimulus outlined above, and also note that CPI growth has recently turned negative, we do think that we are still some way from a sustained and generalised decline in prices across the Eurozone. This is partly because we think that governments in the region are finally waking up to the cyclical challenges and are likely to do more to tackle them. It also reflects the fact that inflation will most likely return to positive territory in the developed world in 2016 as the base effects from last year’s precipitous fall in oil prices wash out of the system. That is not to say that the risk of deflation should be entirely dismissed. The next global downturn, when it comes, will be very ugly in Europe as the institutional framework is still weak and debt dynamics may exert a more sustained downward forces on prices. For now though, until there is more conclusive evidence that falling price trends are being driven much more by persistently weak demand than by a one-off supply shock, we think that the likelihood that the developed world will slip into a genuine bout of deflation is low.

Govinda Finn, Global Strategy, Standard Life Investments

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