Rates hope as Greenspan warns on deflation

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The Independent Online
Central bankers may find themselves having to fight the effects of deflation or falling prices rather than the traditional enemy of inflation, Alan Greenspan, chairman of the Federal Reserve said at the weekend in a speech some interpreted as a signal that US interest rates would remain on hold for much of this year or possibly even fall.

Meanwhile, the new year has brought a wintry flurry of glum reports forecasting that the British economy is on the verge of a sharp slowdown. Diane Coyle, Economics Editor, examines the change in mood.

Mr Greenspan told the American Economic Association that "inflation has become so low that policymakers need to consider at what point effective price stability has been reached. Indeed, some observers have begun to question whether deflation is now a possibility, and to assess the potential difficulties such a development might pose for the economy".

Mr Greenspan made his comments in the context of a wide-ranging and, at times, esoteric speech about the difficulties of measuring price changes in the modern world, and he stopped short of saying whether he believes deflation to be a real threat or how the Fed might respond to such an eventuality.

Even so, Alan Sinai, chief economist at Primark Decision Economics, said that by even mentioning deflation and particularly by discussing its policy implications at such length, Mr Greenspan was at least saying the issue merited discussion. "The Fed seems to be as concerned about deflation as inflation," Mr Sinai, who attended the speech, said. "It's a tip-off they won't raise rates."

However, others cautioned against over-interpretation of Mr Greenspan, who once famously remarked that if anyone understood what he was saying then he had probably been misunderstood.

Mr Greenspan insisted that deflation in the price of goods and services can be as bad for the economy as inflation. "While asset price deflation can occur for a number of reasons, a persistent deflation in the prices of currently produced goods and services - just like a persistent increase in these prices - necessarily is, at its root, a monetary phenomenon," he said.

"Just as changes in monetary conditions that involve a flight from money to goods cause inflation, the onset of deflation involves a flight from goods to money. Both rapid or variable inflation and deflation can lead to a state of fear and uncertainty that is associated with significant increases in risk premiums and corresponding shortfalls in economic activity.

"Even a moderate rate of inflation can hamper economic performance, as I have emphasised many times before; and although we do not have any recent experience, moderate rates of deflation would most probably lead to similar problems."

Mr Greenspan warned that deflation could also be detrimental for reasons that go beyond those associated with inflation. "Nominal interest rates are bounded at zero, hence deflation raises the possibility of potentially significant increases in real interest rates. Some also argue that resistance to nominal wage cuts will impart an upward bias to real wages as price stability approaches or outright deflation occurs, leaving the economy with a potentially higher level of unemployment in equilibrium".

However, the Fed chairman also said that the present debate about deflation lacked clarity and was hampered by the present difficulty of defining what constituted falling prices.

The bogeyman of world-wide deflation has been raised by a number of leading economists and market pundits following escalation of the economic crisis in the Far East. Nearly all economists predict that the crisis will, at least, put a severe break on growth.

Ahead of this week's meeting of the Bank of England's Monetary Policy Committee to decide whether or not to raise UK interest rates, three new reports predict slower growth than in 1997, with a risk that further turmoil in Asia or in the world's stock markets could make the outlook even bleaker.

The most pessimistic vision comes from Oxford Economic Forecasting, a commercial forecasting group, which puts this year's GDP growth at just over 2 per cent or about half the 1997 growth rate. It says the Asian crisis will have a bigger impact on British exporters than many commentators recognise, and adds for good measure that still-buoyant consumer spending is vulnerable to a stock market collapse.

Only slightly more upbeat is Cambridge Econometrics, which foresees 1998 growth of 2.5 per cent, down from 3.5 per cent in 1997. But its vision of a "soft landing" for the economy is darkened by the prediction that the slowdown will last through 1999 and 2000.

Separately, Lloyds Bank warns this morning that middle market businesses will see their profits squeezed by slower growth and the impossibility of pushing through higher prices, even though more of them than ever are now operating at full capacity.

A survey of 2,000 businesses with annual sales between pounds 1m and pounds 100m showed only one in 10 believed they could raise prices during the next six months. More had cut prices than raised them in the past six months.

Even so, nearly half said they were having trouble recruiting skilled staff and a quarter said they could not find enough unskilled employees. Only 11 per cent believed profits would rise in the next six months.

Michael Riding, managing director of Lloyds Bank Commercial Service, said: "Profit growth is at its lowest since 1993 when businesses were still feeling the effects of recession. This will be compounded by an economic downturn."

According to the Oxford forecasters, the downturn will be steep because of the triple whammy of a tough Government budget policy, high interest rates and the strong pound. The economic crisis in South-east Asia will have a bigger impact on the UK than many anticipate, according to Adrian Cooper, one of Oxford Economic Forecasters' economists. "The falls in Asia's currencies have added to the UK's competitiveness problems, particularly for industries such as textiles and consumer electronics."

The report reckons prospects for consumer spending remain bright and will barely slow down from 1997. But confidence is vulnerable to the danger of a stock market crash.