Outlook Here's a thought about the terrifying spectre of deflation now looming large if the much bigger than expected fall in inflation seen last month is a taste of things to come. It may not be so terrifying.
Economic textbooks tell us that deflation is bad news because consumers stop buying stuff in the expectation that prices will fall further. That sends the economy into a tailspin, wages fall and the real value of debt increases. Yikes.
But here's the thing. A headline inflation figure that is negative does not mean the price of all goods and services in the economy is falling – just as the high headline numbers we are currently seeing do not imply that the cost of everything is rising so quickly.
The rise – and now the fall – of inflation is a story of a bubble on the world's commodity markets. By quite some margin, the biggest contributors to yesterday's sharp falls in inflation came from the transport and groceries sectors. Fuel costs fell sharply because the oil price has fallen dramatically since the summer, while similar, though not quite so marked, falls on various soft commodity markets brought down the cost of many staple foods.
These were also the sectors responsible for the rapid upswing in inflation. Indeed, the really alarming thing about rising inflation earlier this year was that the headline measures underestimated the size of the increases in the cost of living for many people, because fuel (especially when you also consider home energy) and food are not areas where spending is discretionary. We all have to eat and heat our homes, and most of us have to travel to work.
This reality will be no different if and when inflation turns to deflation next spring. Chances are you won't postpone your weekly supermarket shop in the hope that a bit of starvation this week will enable you to save a few bob when you do eventually succumb to the hunger pangs. And while some of us may no longer be travelling to work – by choice, or not – we'll still turn the heating on if it's chilly.
The point about deflation, if that's what we get, is that it will almost certainly only be seen in these areas of the economy. If so, the tailspin may be avoided, especially as commodity market professionals are still clinging to their forecasts of price rises sooner or later next year. The International Energy Agency, for example, reckons $80 a barrel for oil might be next year's average price, which is almost 50 per cent above today's figure.
Not that conventional wisdom on deflation is always borne out in any case. Gordon Brown believes his economic policies over the past 11 years are the reason that inflation has been so remarkably low by recent standards. In fact, stunningly cheap imports have played a much larger part, with the price of electronic goods, for example, as well as clothing, falling year after year. So how come consumers didn't hold off buying, say, flat-screen tellies, in the assumption the cost would keep on coming down?
This, by the way, is not to say deflation is to be welcomed. But the way in which the Bank of England has this year had to career from terror about runaway price rises to mortal dread of the opposite scenario does raise some questions about the central plank of the Prime Minister's economic policy. For a long period, the strict targeting of inflation – the Bank must deliver inflation that does not fall or rise more than a percentage point above the 2 per cent bullseye rate – seemed to deliver so much. More recently it has caused more difficulties than it has solved.
In a speech yesterday, Tim Besley, one of the Bank's Monetary Policy Committee rate setters, said he believed it was "essential that monetary policy decisions remain focused on our inflation-targeting mandate". But the problem with the focus is that it is so blinkered. It's now pretty clear that the MPC kept interest rates too high for too long in the summer and early autumn. This was understandable, given the headline rate of inflation, but a wider – or longer-term, at least – mandate might have enabled the committee to cut the cost of borrowing more quickly.
As any driver knows, the big danger when you skid off course is over-correcting the steering as you try to recover the right line. Not cutting rates until September was one such over-correction and the sort of rate cuts now expected from the MPC may prove to be another. Don't be too surprised if some time next year we all stop panicking about deflation and start worrying again about those nasty old price rises.Reuse content