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.

Voices
voicesGood for Lana Del Rey for helping kill that myth, writes Grace Dent
News
The University of California study monitored the reaction of 36 dogs
sciencePets' range of emotions revealed
Life and Style
fashion Designs are part of feminist art project by a British student
News
Joining forces: young British men feature in an Isis video in which they urge Islamists in the West to join them in Iraq and Syria
newsWill the young Britons fighting in Syria be allowed to return home and resume their lives?
PROMOTED VIDEO
Arts and Entertainment
The nomination of 'The Wake' by Paul Kingsnorth has caused a stir
books
Arts and Entertainment
The Tour de France peloton rides over a bridge on the Grinton Moor, Yorkshire, earlier this month
film
News
Snoop Dogg pictured at The Hollywood Reporter Nominees' Night in February, 2013
people... says Snoop Dogg
News
i100
Life and Style
food + drinkZebra meat is exotic and lean - but does it taste good?
Arts and Entertainment
Residents of Derby Road in Southampton oppose filming of Channel 4 documentary Immigration Street in their community
tv
Voices
voicesSiobhan Norton on why she eventually changed her mind
News
ebookA unique anthology of reporting and analysis of a crucial period of history
News
i100
Extras
indybest
Sport
Scottish singer Susan Boyle will perform at the Commonwealth Games opening ceremony in Glasgow
commonwealth games
Arts and Entertainment
Dwayne 'The Rock' Johnson stars in Hercules
filmReview: The Rock is a muscular Davy Crockett in this preposterous film, says Geoffrey Macnab
Life and Style
tech
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

PMO Analyst - London - Banking - £350 - £400

£350 - £400 per day: Orgtel: PMO Analyst - Banking - London - £350 -£400 per d...

Cost Reporting-MI Packs-Edinburgh-Bank-£350/day

£300 - £350 per day + competitive: Orgtel: Cost Reporting Manager - MI Packs -...

Insight Analyst – Permanent – Up to £40k – North London

£35000 - £40000 Per Annum plus 23 days holiday and pension scheme: Clearwater ...

Test Lead - London - Investment Banking

£475 - £525 per day: Orgtel: Test Lead, London, Investment Banking, Technical ...

Day In a Page

Screwing your way to the top? Good for Lana Del Rey for helping kill that myth

Screwing your way to the top?

Good for Lana Del Rey for helping kill that myth, says Grace Dent
Will the young Britons fighting in Syria be allowed to return home and resume their lives?

Will Britons fighting in Syria be able to resume their lives?

Tony Blair's Terrorism Act 2006 has made it an offence to take part in military action abroad with a "political, ideological, religious or racial motive"
Climate change threatens to make the antarctic fur seal extinct

Take a good look while you can

How climate change could wipe out this seal
Man Booker Prize 2014 longlist: Crowdfunded novel nominated for first time

Crowdfunded novel nominated for Booker Prize

Paul Kingsnorth's 'The Wake' is in contention for the prestigious award
Tour de France effect brings Hollywood blockbusters to Yorkshire

Tour de France effect brings Hollywood blockbusters to Yorkshire

A $25m thriller starring Sam Worthington to be made in God's Own Country
Noel Fielding's 'Luxury Comedy': A land of the outright bizarre

Noel Fielding's 'Luxury Comedy'

A land of the outright bizarre
What are the worst 'Word Crimes'?

What are the worst 'Word Crimes'?

‘Weird Al’ Yankovic's latest video is an ode to good grammar. But what do The Independent’s experts think he’s missed out?
Can Secret Cinema sell 80,000 'Back to the Future' tickets?

The worst kept secret in cinema

A cult movie event aims to immerse audiences of 80,000 in ‘Back to the Future’. But has it lost its magic?
Facebook: The new hatched, matched and dispatched

The new hatched, matched and dispatched

Family events used to be marked in the personal columns. But now Facebook has usurped the ‘Births, Deaths and Marriages’ announcements
Why do we have blood types?

Are you my type?

All of us have one but probably never wondered why. Yet even now, a century after blood types were discovered, it’s a matter of debate what they’re for
Honesty box hotels: You decide how much you pay

Honesty box hotels

Five hotels in Paris now allow guests to pay only what they think their stay was worth. It seems fraught with financial risk, but the honesty policy has its benefit
Commonwealth Games 2014: Why weight of pressure rests easy on Michael Jamieson’s shoulders

Michael Jamieson: Why weight of pressure rests easy on his shoulders

The Scottish swimmer is ready for ‘the biggest race of my life’ at the Commonwealth Games
Some are reformed drug addicts. Some are single mums. All are on benefits. But now these so-called 'scroungers’ are fighting back

The 'scroungers’ fight back

The welfare claimants battling to alter stereotypes
Amazing video shows Nasa 'flame extinguishment experiment' in action

Fireballs in space

Amazing video shows Nasa's 'flame extinguishment experiment' in action
A Bible for billionaires

A Bible for billionaires

Find out why America's richest men are reading John Brookes