Effect of falling oil prices

A fall in oil prices should cause a reduction in transport and fuel costs for firms. Consumers who will also benefit from the lower prices of transport and fuel. The lower oil prices will effectively increase their disposable income and enable them to spend more on other goods Because oil is the most traded commodity …

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Problems of deflation

deflation-inflation-20s-30s

Deflation is defined as a fall in the general price level. It is a negative rate of inflation. The problem with deflation is that often it can contribute to lower economic growth. This is because deflation increases the real value of debt – and therefore reducing the spending power of firms and consumers. Also, falling …

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Types of deflation

types-of-deflation

Is deflation good or bad? Mostly experiences of deflation in western economies have been damaging – deflation has been associated with falling rates of economic growth and higher unemployment. However, it is possible to have a different type of deflation – from rapidly improving productivity; then deflation can be consistent with higher rates of economic growth.

The key issue is – what is causing the deflation and if prices are falling – what is happening to real wages and real interest rates?

Deflation caused by lower costs ‘good deflation’

If we have ‘good’ deflation – due to a big increase in productivity, lower costs – then in theory firms will be able to pay real wage increases. With this type of deflation, we are seeing lower prices, but also higher output, higher productivity, higher profits – and hopefully higher real wages. If consumers see lower prices, but they have rising real incomes, then you would expect higher spending because they will have the money to buy these cheaper goods.

sras-shift-right A fall in costs of production lead to lower prices for consumers – but output increases

Example of good deflation 1870-1890

Towards the end of the nineteenth century, the US, UK economies benefitted from a worldwide fall in prices due to the “Second Industrial Revolution”. This included major improvements in productivity:

  • More efficient steam engines
  • Improved steel production (Bessemer Steel)
  • Cheaper cost of railways – railways came of age.
  • Improved communication.
  • The transition from agricultural to industrial production.

The US economy grew rapidly in this period – benefitting from the new technology which helped lower costs. An important feature of this period was that although prices fell, wages were constant or rose and so workers saw real wage growth.

Deflation caused by falling demand

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Deflation caused by a fall in AD.

If we have ‘bad’ deflation – falling prices caused by weak demand, then firms will be seeing a decline in profitability. In this circumstance, firms will not be increasing wages but trying to cut wages. Also, if firms can’t cut nominal wages, we may see a rise in unemployment (a combination of real wage unemployment and demand deficient unemployment).

Therefore, in this scenario of lower wages / higher unemployment, the falling prices will not be sufficient to encourage spending and higher consumption. Instead, people will be risk-averse trying to save and waiting for prices to fall further.

Costs of deflation

If prices are falling but nominal wages are also falling or stagnant, we tend to get these problems.

  • Consumers delay purchases. With falling prices, consumers expect prices to be lower in the future, so put off purchasing goods.
  • Rise in real value of debt. With falling prices and falling wages, it becomes harder to pay off debt and meet debt repayments.
  • Real wage unemployment. With falling, prices firms can’t afford workers, but if workers resist nominal wage cuts, then there will be real wage unemployment
  • Higher real interest rates. Interest rates cannot fall below zero, so if there is deflation, the effective real interest rate rises. Therefore, even if the economy is depressed, real interest rates are high – discouraging borrowing and encouraging saving.
  • Deflationary cycle. In a deflationary cycle, lower demand leads to lower prices, and falling prices cause lower demand, it is a vicious circle.

deflation-spiral

Example of ‘bad’ deflation – the UK in the 1920s and early 1930s

real gdp 1920s

1918-38-unemployment-rate

Unemployment high during the 1920s and early 1930s. See: UK economy in the 1920s

Deflation/low inflation of UK 2010s

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Ignoring cost-push factors underlying inflationary pressures in the UK have been low – with inflation falling to zero in 2015. However, a significant reason for this deflation/low inflation is the poor productivity – and consequent stagnant real wages. Inflation is low, but households are becoming worse off.

index-productivity-80-14

Falling prices led to stagnant real GDP


Readers Question: And regardless of the reason, people should put off buying shouldn’t they?

It can depend on consumer confidence and expectations of future wages/employment opportunities. If we have a period of deflationary pressures – low /negative growth, then people may be fearful about future employment opportunities, they will expect low wage growth, and possibly unemployment – therefore, in this circumstances, consumers will be trying hard to be careful in budgeting and spending. If they think prices will fall and their income may decline, then this is an added reason to delay spending.

However, if there is strong growth, low unemployment and rising wages, there is much less need to be careful with spending – therefore, they will be willing to buy now and enjoy their rising real wages.

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Causes of deflation

Readers Question: What is the cause of deflation? Deflation involves a fall in the price level –  a negative rate of inflation. From a very basic standpoint, there are two main potential causes of deflation: A fall in aggregate demand (AD) A shift to the right of aggregate supply (AS) – i.e. lower costs of …

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Policies to solve deflation / low inflation

us-euro-inflation

Deflation means a fall in prices (a negative inflation rate).

Though policymakers should generally be concerned if there is an inflation rate less than the target of 2%.

us-euro-inflation
Source: World Bank. Low inflation in US and the EUro area in 2009 and 2014 – cause for concern.

 

For example, in the Eurozone Jan 2015, the headline inflation rate is -0.2%. Even if we strip away volatile prices like oil, core inflation is 0.8%. This is a very low rate of inflation.

There are many serious potential problems of low inflation/deflation

  • Higher real debt burdens,
  • Decline in spending,
  • Higher unemployment.

See costs of deflation for more detail.

What options are available to overcome deflation?

Monetary policy

The traditional tool of monetary policy is interest rates. If inflation is too low, the Central Bank can try to cut interest rates. In theory, this should boost spending and aggregate demand. For example, lower rates reduce the cost of mortgage payments, giving people more to spend.

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However, there are times when cutting interest rates are not sufficient. In a liquidity trap – zero interest rates may not encourage sufficient spending. For example, after the credit crunch – lower interest rates failed to boost demand sufficiently. Lower interest rates failed to solve low inflation for many reasons:

  • People preferred to save because of ongoing recession
  • People took opportunity to pay off debts
  • Banks didn’t want to lend, so firms couldn’t get loans despite low rates
  • Banks didn’t pass the full base rate cut onto consumers.

Unconventional monetary policy

With a failure of interest rates, the traditional tool of monetary policy, Central Banks needed to consider unconventional monetary policy. Some of these policies are relatively untried.

Helicopter drop – print money

In theory, creating inflation should be the easiest thing – just print money and according to the quantity theory of money – we should get inflation. A particular policy for printing money is termed the ‘helicopter drop’ – where the Central Bank gives newly created money to consumers directly. Central Banks have been reluctant to pursue this strategy, presumably because it goes against the mentality of serious Central Bankers and their inflation-fighting credentials. But, it would be a solution to deflation. The most challenging aspect would be knowing about much money to print, to get the right amount of inflation.

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GDP deflator

gdp-deflator

GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all new, domestic goods and services in an economy. The GDP deflator regularly updates the type of goods and services used to measure the implicit price deflator – depending on which goods are being bought. e.g.If the price of …

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Why does deflation lead to lower spending not more?

deflation-inflation-20s-30s

Forgive me, I’m not an economist, but I am a working woman and a taxpayer and a consumer. Lowering prices does NOT encourage us to put off spending…if I see something I want or need for a lower price you can bet your butt I’m getting it before the price goes back up!

When an economy experiences deflation (general fall in price level) we tend to also see:

  • Falling revenues for firms (prices go down) therefore they get less revenue.
  • Falling wages. Firms can’t afford wage increases, so wages start to fall (or stagnate) leading to lower income. For example, in Japan between 1997 and 2012 Average earnings fell 12.2 percent, while a core measure of consumer prices — excluding food and energy — fell 6.8%. (NY Times)
  • Rise in unemployment. Often wages can’t fully adjust downwards, but firms can’t afford to pay workers. Therefore workers are made redundant and we get real wage unemployment.

If the price of a particular good goes down, this will increase demand for that good. (especially, if people think the price cut is temporary like a special offer)

However, deflation is a different situation. This is when all prices are falling (not necessarily all prices, but the average price level is falling). Furthermore, people expect prices to keep falling because of the deflationary pressures. If a TV has fallen 2%, but you expect a TV to fall another 2%, then you are more likely to delay buying because it will be cheaper  next year.

An important factor here is that peoples expectations of inflation / deflation are closely related to current inflation. If current inflation is 3%, this is what people expect future inflation to be. If there is deflation of 2%, that will be people’s future expectations of deflation.

Another important factor is that deflation invariably means falling wages. So consumers have two factors which lead to lower spending during inflation

  • The expectation prices will continue to fall.
  • The fact nominal wages are falling and they have less income to purchase goods. In 2012, Japan, a survey of consumers found  94 % expected their wages to remain the same or fall, and 96% expected to maintain their spending levels or cut them. The survey has shown the same underlying trend for nearly 20 years.

A good empirical example of the impact of deflation on consumer spending can be seen in the 1930s depression and Japan’s period of deflation during the 1990s and 2000s. Also, deflation during the 1920s was damaging for the UK economy.

deflation-inflation-20s-30s

Another real problem with deflation is that it is much harder to solve. E.g. the Central Bank can’t cut rates below zero. Therefore, once deflation is embedded, it becomes quite rational to expect continued deflation – this is one factor which makes deflation so damaging.

Why does Deflation increase the value of debt? It’s all just dollars and cents…if the value of our dollar goes up, yes the value of the debt does too so its still proportional to our currency value. So saying that the value of our debt goes up is a little misleading. It’s not going up independently and we suddenly don’t have the same amount of money.

The important feature is that deflation invariably means falling wages.

Suppose your mortgage payments are $500 a month, and your wage is $2000. You spend 25% of your disposable income on paying mortgage debt. However, if we have deflation and your nominal wages are being cut, then you have to spend a higher % of your income on paying your debt. If your wage fell to $1900, you would have to spend 26.3% of your income on your mortgage debt.

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Deflationary Bias in the Eurozone

Readers Question: Is there an inbuilt deflationary bias in the Eurozone?

Note: I originally wrote this post in 2010. Unfortunately, every year there is a reason to update the post and suggest the deflationary bias in the Eurozone keeps getting stronger.

eu-inflation

Deflationary bias means that there is a tendency for economic policy to promote lower growth and lower inflation. It means there are pressures which keep demand subdued leading to lower inflation, higher unemployment and lower growth. Now, we are seeing outright deflation (fall in prices)

I agree that there is a deflationary bias in the Eurozone. This is proved by the long period of low economic growth (2007-15) and an inflation rate that is remaining well below target. Headline inflation in the Eurozone has fallen to -0.2% (Outright deflation, though core inflation, is still 0.7%). Growth is anaemic and unemployment well into double figures (11%) – Unemployment is higher in Europe than many other countries.

European Unemployment Eurozone vs Non-Eurozone economies

eurozone-unemployment

Source: Eurostat

Although core inflation is still positive. Many countries on the periphery are experiencing a real threat of prolonged deflation.

What explains the deflationary bias of the Eurozone?

Low Inflation Target

The ECB have very strong attachment to keep inflation less than the target of 2%. For example, in 2011, temporary cost-push inflation, led to an increase in the EU headline inflation rate. The ECB responded by increasing interest rates. The Bank of England responded by keeping interest rates at 0.5% (even though inflation was much higher in the UK than EU). The Bank of England argued it was important to give importance to wider economic issues of growth and unemployment. The ECB were much less willing to accept, even a temporary deviation from the inflation target over fears temporary inflation would increase inflation expectations. It showed the ECB are much more willing to risk lower growth than risk higher inflation. (see also: ECB v Bank of England)

Whilst the ECB have an inflation target, they have no explicit target for unemployment or economic growth. EU Unemployment has risen to 12%, but there has been little action to increase aggregate demand.

The ECB have worried than any unconventional monetary policy may reduce their credibility and long-term ability to tackle inflation.

Reluctance to pursue unconventional monetary policy

Despite a prolonged period of low inflation, the ECB have been very reluctant to actually implement unconventional monetary policy  (e.g. Quantitative easing). It took outright deflation to finally push the ECB into proper Q.E, in Jan 2015.

The ECB is reluctant to engage in any quantitative easing because

  • They are reluctant to create any possibility of future inflation, printing money is an anathema to German Central Bankers, who wield considerable influence over ECB monetary policy.
  • The ECB has a reluctance to start buying bonds of different countries, deciding which to buy; and there have been constitutional excuses for not printing money.

The result is that countries with many deflationary pressures (strong exchange rate, fiscal austerity) don’t have any monetary stimulus to offset the fall in demand. (e.g. UK can pursue quantitative easing when we experienced deep recession). Countries in Eurozone can not.

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