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Economic View: Bogey of inflation in danger of being deflated

Could inflation revive, or is deflation set to rule? This is the great question affecting not just all financial markets and all companies, but all of us as savers and borrowers. The financial markets (and I suspect most of us as individuals) make an explicit assumption that inflation will tick along at about 3 per cent for the foreseeable future, at least in the UK. That is why it typically costs between 7 and 8 per cent for a mortgage: 3 per cent for inflation, and another 4 to 5 per cent real cost.

But maybe this will be wrong. The annual inflationary outcome could average anything between zero (or maybe a negative, for that happened for much of the last century) and the high single figures if inflation revives. Most professional investors, if pressed, would expect the outcome to err on the downside. At the moment the risks of deflation appear greater than that of revived inflation.

But that judgement, too, may be wrong. Perhaps inflation, in the short term at least, could come up quite fast. Perhaps, on the other hand, deflation could become much more serious than it seems now.

These twin dangers are the key points tackled in the new Bank for International Settlements annual report, published yesterday. For people unfamiliar with this publication, it is perhaps the best annual survey of the state of the world economy that anyone produces. It is a central bankers' view for the BIS is the central bankers' bank.

Perhaps it is that, or maybe something about being located in an ivory tower in Basle that gives a clarity and judgement to its views - or maybe, less charitably, the BIS simply has a number of high-quality people without a lot else to do. Be that as it may, for anyone interested in the interaction between financial markets and the world economy the BIS annual report is very good.

There is usually a theme to each year's commentary and this year it is that the moment of victory over inflation carries dangers of a different kind.

Price stability, the Holy Grail of central bankers, "has been reached, or almost reached, in a large number of countries in the industrial as well as the developing world". Instead there is the danger of disinflation: " ... disinflationary forces will continue to exert an influence, as will the effects of excess capacity which still characterises many of the industrial countries other than the United States."There is still an inflationary threat, and this comes from two rather different sources. In North America the economy is close to full capacity; in Europe the level of structural unemployment may create such pressures that inflation is seen as a way out. In addition, many developing countries have high inflation. But on balance the forces bearing on inflation - those pushing it up and those pushing it down - are more balanced than for many years. With a nice long perspective, the BIS likens the present situation to that of the early 1920s when Keynes and Wicksell noted that central banks should be ready to resist both inflation and deflation.

This reflection in itself is interesting, for throughout the post-war period it has been assumed that the appropriate stance for central banks is to lean against inflation. That position is still reflected in what central bankers always say, though not necessarily in what they do. Now the annual report of the central bankers club is warning of the other danger. That is a significant shift, reflecting a changed reality.

Besides, the BIS points out, the two most important macro-economic problems in the world have disinflationary implications. These are fiscal deficits and reform of labour markets, particularly in Europe.

The graphs, drawn from the BIS report, show these two problems for the three main developed country economic zones, the US, Japan and the European Union.

As you can see, the fiscal problem (the dotted line) is common to all three areas, now that Japan has plunged into deficit.

Add in the demographic changes each region will experience over the next 25 years and the underlying deficits are even larger. The longer a correction is delayed the greater the scale of the problem being generated. But of course in the short-term correcting a fiscal deficit probably has disinflationary effects.

The unemployment threat is also highlighted. Here the three zones have very different experience: the US has unemployment under control; in Japan it is concealed (the BIS took the ratio of actual to potential GDP as a measure of slack in the labour market, rather than actual published unemployment); and in Europe it is dreadful and getting more so. The danger is that the method of correcting these European levels of unemployment - freeing up labour markets - will in the short-run make the problem appear worse. The BIS does not say so, but UK experience is interesting here. We now have lower unemployment than the other large European economies thanks to labour market reforms which have made it possible to expand the economy without running into pay pressures. But for much of the 1980s, only the unemployment was evident: the pay-off was not yet clear.

So what happens now? The BIS has no magic wand. It can warn that policies need to be balanced. It argues that alongside price stability we have to maintain financial stability, noting that the banking system in a number of countries, in particular Japan, remains fragile.

It devotes a considerable part of its conclusion to managing financial crises. Some readers may feel there is a coded signal here that the BIS expects a rough period in the markets somewhere in the near future, but that is conjecture.

There is not quite a warning about present share price levels and the narrowing of the differential on low-quality bonds, but the phenomena are noted with this coda: "The potential for an abrupt change in this appetite for risk should not be underestimated."

The big point here, surely, is that we are on the cusp between the inflationary era which has dominated the entire post-war period, and something different.

For the entire lives of most people in the developed world there has been a background of inflation. Sometimes that has been suppressed by pay and price policies; sometimes it has burst through into very rapid inflation - in some countries hyper-inflation. Sometimes it has simply receded into a background concern, something in the back of people's minds when they enter into a long-term financial contract, like the purchase of a house or a pension policy.

Now there is something different. Maybe there will be a new sudden surge of inflation, which could run for a while.

But it is hard to see that lasting, given the power of the bond markets to thump up interest rates, and the low-wage economies of East Asia to produce goods similar to our own at much cheaper prices.

But perhaps the something different is a longer period of deflation, something more akin the 1920s. It is good to have central bankers warning of the dangers of deflation. This is both important and new.