Learning to live in a world of falling prices

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The Independent Online
IT HAS been a week where deflation has reached the UK. Among the main developed countries Britain has been towards the top end of the inflation range. But Monday's wholesale price index showing the price of goods falling faster than at any time for 40 years, and Tuesday's retail price index showing prices falling in key high street goods such as shoes, clothing and hi-fi, make it clear that Britain has joined the pack.

One measure of global deflation which I had not come across until a few days ago is shown in the left-hand chart, produced by the New York bank, JP Morgan. The bank monitors 45 countries, noting what is happening to inflation, and records the number of those countries where the year-on- year rise in consumer prices is below 1 per cent.

Given the difficulties of allowing for quality improvement in products and particularly services, anything below 1 per cent is really stable prices. So we have gone from a situation eight years ago when there were one or two countries with near-zero inflation to 11 now.

Expect more next year. It is not yet appearing much in the official forecasts, but inflation in the countries participating in the euro, the so-called euro-11, may well be below 1 per cent next year. The latest annual producer- price figures for the US, the euro-11 and Japan are minus 0.7 per cent, minus 1.7 per cent and minus 2.9 per cent respectively. Expect these falls to move through into consumer prices in the months to come, particularly as the growth in demand weakens.

We have so little experience of price stability that it is very hard to adjust to it: only people with a memory of the 1930s are really able to comprehend how it might affect not only asset prices but also the conduct of businesses. There is an immediate message of lower interest rates world- wide, which many people are now taking on board. But beyond that we have hardly begun to think about this new world. So here, in no particular order, are some of the areas where surprises might occur.

One very obvious one is in UK policy. The Bank of England is supposed to aim for an inflation target of 2.5 per cent, a target which it is now hitting. That may however appear completely out of line with the general level of world inflation. We obviously cannot have a rate of inflation which is far above that of other developed countries, and 2.5 per cent may be too high. Crunch time will come next year, if inflation in the US and the euro-11 drops sharply.

A second area of potential surprise could be the speed of decline in interest rates world-wide, and the ineffectiveness of rate cuts as a means of stimulating the economies concerned. The UK economy is very sensitive to changes in short-term rates because much of our housing is financed by loans tied to these rates. But most economies are not. Home loans are generally at fixed rates and so are not directly affected by rate changes, while interest payments are a significant source of income for many retired people. So there may be other examples of the Japanese phenomenon, where a cut in interest rates reduces demand rather than increasing it. Germany is an obvious candidate.

The third area of surprise may be how low bond yields might go. The graph on the left, taken from The International Bank Credit Analyst, shows US bond yields since 1830. The interesting period is the one between 1870 and 1900, which roughly corresponds with what was, until the 1930s usurped the phrase, the great depression. It was a period of gently falling prices, and generally falling bond yields. But even at the end of that period, yields did not go below 3 per cent, as they did in the 1940s and early 1950s when there was some (albeit very modest) inflation.

So the question arises: what are the appropriate yields for long-dated US government stock in this deflationary world? Should the big number at the front be four, three or even two? UK long rates seem curiously low at the moment relative to US and German ones, but there is clearly scope for falls in rates elsewhere.

The fourth area of surprise may turn out to be in the very different performance of companies in different parts of the commercial forest.

There are some chunks of the economy where price destruction has yet to take hold. As we reported yesterday there are areas like personal services, magazines and other subscriptions where prices have been going up by 6- 7 per cent a year. By contrast oil and other fuel and audio-visual kit are down 16-17 per cent. If these trends continue and, in addition, deflation becomes more general, we may have a situation where only companies providing services can charge more for their output. Companies making things will all end up charging less.

It is possible to increase profits despite delivering ever-cheaper products, but it is not easy. Expect companies whose output is intangible to continue to benefit relative to those whose output is tangible - at least until price destruction hits service companies too, as it has in mobile phones.

Area of surprise number five is the public sector. The public sector has been accustomed to being able to charge more for its output, using the general excuse of rising costs. For example we all expect the council tax to rise as part of general inflation. But if prices in general are stable, the excuse of rising costs becomes untenable.

Expect profound pressure on the public sector, not just here, but throughout the developed world, to live within existing tax revenues. Indeed, if prices fall, indirect tax revenues will fall too. That is happening to general tax revenues in Japan, and could happen to European VAT revenues. I don't think governments have begun to think about the consequences of a world where they have to live with revenues that tend to fall each year, instead of rising.

They will, if the trend of the last few weeks does indeed take a sharp further downward twist in 1999.

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