Problems of deflation

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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-rightA 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.

Read moreTypes of deflation

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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Impact of falling oil prices

In recent months the price of crude oil has fallen 50%. This fall in the price of oil has a significant impact in reducing transport and other business costs. Falling oil prices is good news for oil importers, such as Western Europe, China, India and Japan; however, it is bad news for oil exporters, such as Venezuela, Kuwait, Iraq and Nigeria.

oil-prices

Impact of lower oil prices on oil consumers

Lower oil prices help to reduce the cost of living. Oil-related transport costs will directly fall, leading to lower cost of living and a lower inflation rate. Falling oil prices is one reason behind the fall in UK inflation to 0%

With stagnant real wages, this fall in the cost of living is important for giving Western consumers more discretionary income (more income to spend). A fall in oil prices is effectively like a free tax cut. In theory, the fall in oil prices could lead to higher spending on other goods and services and add to real GDP.

Macro economic impact of falling oil prices

  1. Lower inflation
  2. Higher output

sras-shift-right

This diagram shows that a fall in oil prices (and a fall in firms costs) will shift the short-run aggregate supply (SRAS) to the right, causing lower inflation and higher real GDP. (Some economists say a 10% fall in oil prices leads to a 0.1% increase in GDP (BBC article on falling oil prices)

3. Balance of payments

Oil importers will benefit from a falling oil price because the value of their oil imports will drop. This will reduce the current account deficit of oil importers; this is important for a country like India who imports 75% of oil consumption and currently has a large current account deficit. However, for oil exporters, a falling oil price will do the opposite reducing the value of their exports and causing lower trade surplus. The UK is currently a small net importer of oil, so will have limited impact on UK current account.

Oil exporters

For oil exporters, a falling oil price is bad news. Many oil exporting countries rely on tax revenue from oil production to fund government spending. For example, Russia gains 70% of all tax revenues from oil and gas. Falling oil prices will lead to a government budget deficit, and will require either higher taxes or government spending cuts. Other oil exporters like Venezuela are relying on oil revenues to fund generous social spending. A fall in oil prices could lead to a significant budget deficit and social problems.

Other oil exporters, such as Saudi Arabia and UAE have built up substantial foreign currency reserves; they can afford temporary falls in oil prices because they have substantial reserves. This is why Saudi Arabia has so far not responded by cutting output.

Why falling oil prices is not enough for Europe

Usually falling oil prices would be welcomed by oil importing countries. However, many are deeply fearful about prospects for the European and global economy.

Firstly, the fall in oil prices is largely a reflection of weak global demand. Continued low growth around the world, is holding back demand. Thus the falling price of oil is a reflection of weak global growth – rather than the harbinger of economic recovery.

oil-deflation

Deflation nightmare. The biggest fear in Europe at the moment is the slide towards deflation and the fear of a ‘Japan-style’ lost decade. EU inflation has fallen to a five-year low (0.4% in August 2014) 31% of Eurozone goods are now falling in price. This is a concern because deflation tends to cause serious macroeconomic problems:

Read moreImpact of falling oil prices

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.

Read morePolicies to solve deflation / low inflation

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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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

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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.

Read moreDeflationary Bias in the Eurozone

Inflation target during deflation

Readers Question: How does inflation targeting operate when there is a deflation? and what are the problems associated with this?

It’s a good question to ask at the moment, especially with regard to the ECB and Eurozone.

Firstly, the EU inflation target is – below but close to 2%. If inflation falls below 2%, the Central Bank should pursue a loosening of monetary policy – lower interest rates (if possible), quantitative easing and allowing the exchange rate to fall.

The ECB state

By referring to “an increase in the HICP of below 2%” the definition makes clear that not only inflation above 2% but also deflation (i.e. price level declines) is inconsistent with price stability.

Basically, the ECB target is 2%

The UK has an inflation target of CPI 2% +/-1 (i.e an inflation rate of 1-3%)

If inflation falls below the target then this is a problem and Central Banks should be committed to solving it.

How to increase the inflation rate?

If inflation is falling below 1% – or even forecast to be falling below 1% a Central Bank should intervene. There are several things it can try and do.

1. Reduce interest rates. Lower interest rates make borrowing cheaper and should help to stimulate demand. However, for the UK and the EU, interest rates are already at zero. Therefore, interest rates are not an effective tool for fighting deflation.

The ECB themselves mention a problem of deflation

“Having such a safety margin against deflation is important because nominal interest rates cannot fall below zero. In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation.” (ECB Price stability)

2. Quantitative easing. – Money creation. In the UK and US, the Central Banks have electronically created money to purchase bonds and gilts. This has increased the monetary base and in theory increased the money supply in the economy. The effect of Q.E. is hard to quantify but it does seem that the economic recovery in UK and US has been stronger – with a higher inflation rate than Europe – Europe is reluctant to pursue Quantitative easing and as a result is seeing its inflation rate fall close to 0%.

The problem Europe has is that many (especially in Germany) have an almost irrational fear of creating money. Any policy of Q.E. could see itself challenged in European courts. It is also more difficult when you have a common currency area of many countries, whose bonds do you buy?

Read moreInflation target during deflation

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