Economics: An era of low inflation beckons
Sunday 30 July 1995
That is probably right. But what about the bigger question: is the worldwide long-term downward trend in inflation, evident since the late 1970s, still secure? Will we in 10 years' time have become accustomed to zero inflation, even (as in Japan at the moment) falling prices? For if that downward trend is secure, anything that might happen here in the next few months will come to be seen as a little blip on the graph. And even the blip may be less marked if worldwide deflationary forces are stronger than the pundits currently believe.
Anyone determined to worry about inflation can trot out a series of justifications for their concern. Some of these are specific to individual countries: for example, that the Federal Reserve was too eager to cut US interest rates earlier this month; that German inflation has been stubbornly high; or that the UK Government will try to encourage a pre-election boom - albeit on a less spectacular scale than in the late 1980s. Others are more general. Of these, the most important at the moment is the fear that last year's surge in commodity prices has yet to work through the system and therefore there is considerable inflation in the pipeline.
Commodity prices are important not because the prices of raw materials (with the possible exception of oil) loom particularly large in industrial costs, but rather because they are at the start of the price chain. As the world economy expands, it typically uses more raw materials, the supply of which cannot be increased quickly. Prices rise sharply, which in turn push up producer prices, which in turn push up retail prices. Workers then see their real wages squeezed and accordingly bid up their own wages, which then puts further pressure on prices, and so on.
When commodity prices shot upwards last year, there were considerable fears that this was the start of just such a cycle. It might be a less marked cycle than those of the 1970s and early 1980s, but it was a cause for concern nonetheless, particularly in countries (such as Britain) that did not compensate for rising raw material prices by having an appreciating currency. Indeed, much of the concern here about inflation is based on the fear that these external cost pressures have still to work their way through the system. But is there really trouble in the pipeline? And could a significant fall in commodity prices race to help?
The background to these questions is given in the chart on the left, showing nearly a century of commodity prices, excluding oil. Most obviously, the long-term trend of commodity prices, expressed in real terms, is downward. This makes sense. As the world economy has developed, it has gradually become more efficient in the use of raw materials: the new electronics industries use much less physical product than the old electro-mechanical ones.
Aside from that downward trend, four further things stand out: the jaggedness of the fluctuations about that trend; the fact that we are now pretty much in line with the trend; the fact that while periods of global depression such as the 1930s were associated with lower-than-trend commodity prices, the long period of steady growth during the 1950s and 1960s also saw lowish prices; and that the worst period for prices (worst, that is, from the point of view of the consumers, not the producers) was the very high inflation period of the 1970s.
The contrast between the 1950s and 1960s on the one hand, and the 1970s on the other, is instructive. It proves nothing of course, but it does suggest that the present downward trend in inflation is quite likely to be reinforced by lower-than- trend commodity prices. It is perfectly plausible that we could have another decade or two when prices fall not just in real terms but in money terms, too.
What about the shorter term? One of the problems of analysing commodity prices is that they are stuck by lots of shocks - agricultural products are hit by poor harvests, while all commodities are affected by speculation. To try to iron out these shocks and look at the broad demand, Kleinwort Benson has constructed an indicator that scales down any large movements - the idea being to produce an indicator that focuses on changes in demand for commodities rather than fluctuations in prices or changes in supply. The result is the graph on the right. It shows that the commodity boom is over in the sense that prices are no longer tending to rise - a point confirmed by The Economist Non-Oil Commodity Index, which peaked at the beginning of this year. That would be consistent with a pause in worldwide growth. Kleinwort reckons that the balance of probability is that commodity prices will now move from the neutral zone into a down phase, though it does not think that commodity prices will fall off a cliff. If the world economy avoids a sharp slowdown in the next 18 months, commodities should be able to hang on to their recent gains.
Kleinwort uses this as an indicator of the state of the world economy, the theory being that commodity prices are available on a daily basis, and so tell us what is happening much more quickly than the regular indicators. But telling us about pressure in demand for commodities also says something about the relationship between that demand and prices. It looks very much as though the worst of the commodity price upsurge was past even before there was any evidence of a slow-down.
Looking ahead, therefore, the balance of probability is surely that commodity prices are at worst a neutral force for inflation, at best a very helpful one.
As far as Britain is concerned, it may well be that the surprises on inflation, if there are to be any, will be pleasant rather than unpleasant. The inflation in the pipeline is there, and nothing can be done about that. The whole economic process, from manufacturing through to retailing, is under great pressure as companies find that competitive conditions are such that they can only pass on price increases to a very limited extent. But a modest recovery in sterling, coupled with a modest fall in commodity prices, would greatly reduce the pressure at the beginning of the chain. And some slowing of the rate of growth will ensure that competition contains prices at the other.
This leads to some conclusions for Britain. Ever since the Bank of England launched its quarterly Inflation Report, inflation has tended to turn out better than forecast. Sooner or later, one might assume, it is going to turn out worse. But with a little help from commodities, it may continue to surprise.
And the rest of the world? It is really very difficult to see sustained inflationary pressure anywhere. The failure of last year's mini-boom in commodities to lead to much higher prices in the developed world means it is safe to assume that the downward secular trend in inflation is indeed secure.
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