Stephen King: How the US economy is giving deflation a new respectability

A world of 'good' deflation would make life a lot more complicated for central banks
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The Independent Online

Something really odd is happening. I mentioned it a few weeks ago, and I just can't get it out of my mind. The dollar is weak, but US inflation is falling. Oil prices are high, but US inflation is still falling. US growth was very strong in the second half of last year, yet US inflation still keeps falling. Anyone who's delved into economics textbooks will know that THESE THINGS ARE NOT MEANT TO HAPPEN. Currency weakness, commodity price strength, buoyant economic activity: in the old days, these were the essential ingredients, the key drivers, for higher inflation.

This time, though, things are genuinely different. Inflation has persistently surprised on the downside, so much so that we now have core inflation in the US - excluding the volatile food and energy components - running at an annual 1 per cent. Lower, in other words, than the European Central Bank's inflation target. Lower than the Bank of England's inflation target. And were the Federal Reserve itself ever to adopt an inflation target, lower than anything that the Fed's own governors would be likely to contemplate.

This low rate of inflation creates a paradoxical situation for central bankers. The markets now expect the Federal Reserve to raise interest rates sooner rather than later - a view partly supported by the Fed itself in its latest Federal Open Markets Committee (FOMC) minutes. The reason for this expectation rests very much on the strength of economic growth, together with the telltale "inflationary" signals coming from commodity prices and the weakness of the dollar.

But if it turns out that inflation is not responding in the usual way, what should happen? I can think of three reasons why, in these circumstances, it might still be appropriate to have higher interest rates. First, it may simply be that inflation itself is a lagging indicator. Why wait around to see what's likely to happen to measured inflation if, in the meantime, an inflationary psychology has already taken hold? Second, there might be evidence of higher inflationary expectations building in other areas: higher house prices or higher bond yields might be an indication of slowly building inflationary pressures. Third, with a strongly expanding economy, it might be appropriate to aim for higher real interest rates, reflecting a higher demand for capital and a higher real growth rate: in this situation, nominal rates might need to rise even if inflation itself remains largely quiescent.

And this is where it gets really interesting. Let's take the third argument a little further. Suppose that higher real rates really are needed. There are two ways of achieving this. Nominal interest rates could rise. Or, alternatively and more unconventionally, inflation could fall for a given level of nominal interest rates. Either way, real interest rates would end up higher.

Wouldn't it be extraordinary if declines in inflation let central bankers off the hook? Wouldn't it be a surprise if, rather than interest rates having to move up and down to regulate the economy, inflation did all the work instead? And wouldn't it be a shock were it not just inflation moving up and down that delivered the right result but, even more bizarrely, the price level itself moving up and down?

Imagine a world where nominal interest rates hardly ever had to change, precisely because real interest rates were regulated by movements in the price level. In this world, the conventional wisdom would be turned on its head. Periods of high inflation would be associated with relatively low real interest rates, consistent with periods of low returns and, hence, relatively weak growth. Periods of low inflation - and, for that matter, deflation - would be associated with relatively high real interest rates, consistent with periods of high returns and, hence, relatively strong growth. This really would be a topsy-turvy world.

And yet it could just be that we are already in this world. To understand why this might be so, I want to distinguish between "good" and "bad" deflation. "Bad" deflation is the one that most of us are intuitively familiar with: people who have borrowed a lot and are awash with debt suddenly find themselves facing falling prices and falling wages. As the wage and price level declines, these borrowers find that their debts are rising in real "inflation-adjusted" terms. As they try to pay off these debts, demand in the economy gets weaker still, deflation gets worse and the whole sorry tale repeats itself again. This is very much a "demand-led" story.

"Good" deflation is a little less familiar, but perfectly coherent nevertheless. "Good" deflation is likely to occur where prices persistently fall more quickly than wages, thereby ensuring that "real" wages rise. On the whole, people get steadily richer. Even those who have debts may not be any worse off: although the real level of the debt may be rising as prices fall, this need not be a problem so long as real wages are rising quickly enough to ensure that the debt/income ratio does not start to pick up.

So what could trigger "good" deflation? From an individual country's point of view, the most obvious mechanism is via a steady improvement in the terms of trade delivered through persistent declines in import prices. Why should import prices decline? One obviously relevant way is through outsourcing and offshoring. If greater capital mobility ensures that resources around the world are allocated more efficiently, the global economy should move closer and closer to the theoretical production frontier, potentially making at least some people better off without having to make anyone else worse off. This is very much a "supply-led" story.

Falling import prices are one way of delivering exactly that result - and might explain why, despite the weakness of the US dollar, import price inflation has remained very low, even if it hasn't been quite so well-behaved as in the euro area, hardly surprising given the euro's persistent strength (see chart). As import prices decline, domestic consumers have more money to spend on other things. As that spending increases, so might the growth rate of the economy as a whole - reflecting the faster progress towards the theoretical production frontier. And that faster progress, in itself, will require higher real interest rates which, of course, can be delivered through falling prices for any given level of nominal interest rates - a not uncommon feature of the UK in the 19th Century.

If this is the world that we're moving towards - and, at this stage, this can be no more than a highly speculative conclusion - it raises all sorts of issues for central banks, for governments and for the population at large. A world of "good" deflation would make life a lot more complicated for central banks. No longer could they easily claim that there was an "ideal" rate of inflation because the "ideal" rate would vary depending on the required real interest rate at any one point in time.

Governments would be faced with some rather awkward issues: unless they framed their government spending in real rather than nominal terms, they could suffer persistent deficit overshoots as nominal revenues came in lower than expected.

For the population at large, though, "good" deflation could be a blessing. Just think of all those people fast approaching retirement age, having to get used to the idea of living on fixed nominal incomes. "Good" deflation would suddenly mean that these fixed nominal incomes would be able to rise in "real" terms. Deflation isn't always bad and, in this topsy-turvy world, price stability may not always be so good.

Stephen King is managing director of economics at HSBC