Pricing out inflation

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Why is the trend of inflation worldwide still heading down? It was not difficult to link the general fall in inflation over the past three or four years with the economic cycle: recession brought falling pay settlements, falling property prices, and low demand for commodities.

Explaining why inflation has failed to rise with recovery is harder. Even in the US, the first country to climb out of recession, inflation has remained subdued despite low interest rates. Here in Britain, now more than a year into recovery and also with quite low interest rates, there is very little sign of a return of inflation. This is despite the depreciation of sterling, which inevitably boosts import prices. Viewed globally, wholesale prices are falling: countries that have devalued their currencies show very little rise in producer prices, while in those whose currencies have appreciated, producer prices are falling.

This suggests a structural force holding down prices worldwide. What might this be? In the mid- 1980s, people attributed disinflation to high global interest rates, but this is hardly the case in the US now. One explanation comes from the investment bank CS First Boston - that it is the impact of competition from China and the other new industrial nations on the world economy.

CSFB argues in terms of the impact on UK price trends. In a country like Britain, whose currency has depreciated, importers are forced to avoid price rises by consumer pressure. Accordingly, they scout about for lower-cost suppliers, particularly in East Asia. As a result, import volumes from what we now have to call the European Union are down 10 per cent since September last year, while imports from non-EU countries are up 10 per cent. Imports from East Asia have risen within that non-EU total. So devaluations speed up the impact of those new regions on the world economy.

One could, however, apply the same argument to the countries whose currencies have appreciated. In Japan, one of the most marked effects of appreciation has been to force producers to switch sourcing to low-cost countries - again in the rest of East Asia.

Currency movements may be little more than a catalyst: they concentrate the minds of importers and exporters alike as to how they might reduce costs. The obvious way of so doing is to use the opportunities created by the new low-cost industrial nations.

It is worth pushing this argument one stage further. One important feature of the world economy since the mid-1980s has been the emergence of new low-cost competitors. Each region has them: the US has Mexico; the EU has Eastern Europe; Japan has Korea, and the other established East Asian producers have mainland China. Competition is not new, but the coincidental arrival of such potentially powerful producers must have an impact on the world economy.

There is a parallel here with the last century. One of the key forces holding down world price levels then was the rapid spread of industrialisation - from Britain to North America and Continental Europe. However, during much of the post-Second World War period, there have - with the important exceptions of Japan and a handful of small East Asian states - been no new industrial nations. Japan and its neighbours have forced greater efficiency in many established industries of the West. They have held down prices in consumer electronics and improved quality in cars. But they compete on quite a narrow front and have not had an obvious impact in areas where they do not export.

Now there is the possibility of a rapid spread of industrialisation analogous to that which took place in the last century. Eastern Europe and Russia are no longer held back by a hopeless economic system. China has allowed the market economy to spread through a fair proportion of the country. And Latin America is weaning itself off the fatal cocktail of import controls and subsidies that it has force-fed to its industries.

If this argument is right, and if the economic reforms of these three areas are carried through, there will be downward pressure on the price of manufactured goods for another generation. Structural change in the world economy will add to the other forces that are already holding down world prices: the discipline of world financial markets, and (probably) the voting preferences of an increasingly old electorate in the industrial world.

Holding down the prices of internationally traded manufactures will not, of itself, ensure that inflation of all goods and services remains low. Manufacturing accounts for only 20-30 per cent of the economies of 'industrial' countries. It is quite difficult to see quite how competition from mainland China could help hold down costs in non-traded services, like health care or education. But stable or falling prices in traded goods will have an impact on purchaser psychology and make it more difficult for service industries to use inflation as an excuse to put up their charges - and as a result, contribute to a general disinflationary climate.