Why the world is not threatened by deflation

Gavyn Davies on the Collapse in the Far east

The phenomenal recent volatility in stock markets around the world has raised the spectre of global deflation in the minds of many investors. The decline of about 10 per cent in world stock prices which was seen before the rebound last Tuesday was the first such setback in equities in the past 25 years which had not been preceded by a rise of at least 50 basis points in global bond yields.

In other words, market paranoia on this occasion was not triggered by the usual concerns that inflation would rise and that this would be followed by higher nominal interest rates, leading to a decline in both bond and equity prices. Instead, the panic in the past few weeks has been triggered by precisely the opposite factors - downward pressure on goods prices, leading to declines in profit margins, and potentially then to global deflation.

As deflation sets in, real interest rates may rise, because central banks are unable to reduce nominal interest rates in line with price declines, so monetary conditions are unintentionally tightened. This tightening then leads to further declines in demand - ie to a self-reinforcing slump. Bond prices rise sharply as equity prices collapse. To those investors who were raised in the inflationary 1970s and 1980s, and who may therefore think that this story sounds inherently implausible, there is no need to look back to the 1930s to find a real-life example of the havoc that deflationary forces can wreak - just look at Japan today. Last week, it was possible to find plenty of investors who believed that the chilling Japanese example was likely to spread to the rest of the world.

Support for this view is evident in the recent behaviour of world producer prices, which measure the prices of manufactured goods as they leave the factory gates. At the start of 1997, the six-month annualised inflation rate for producer prices in the major economies was around 2 per cent. Now, following the collapse in Asian activity, this inflation rate has declined to -1 per cent. In other words, deflation is already visible in the goods sectors of the OECD economies.

However, much of this reflects earlier developments in commodity prices, which fell sharply in the first half of this year, primarily triggered by a major weakening in energy prices. Commodity prices have rebounded strongly in the past three months, and importantly there are no signs of a significant fall in overall commodity demand at present, particularly for energy products.

Admittedly, the Asian meltdown shows every sign of getting much worse before it starts to improve, and this will sharply curtail global aggregate demand. There are also some fears that a decline in global equity prices could damage confidence and thus depress consumer spending in the US and elsewhere. Taken together, these factors could certainly depress global inflation, and if they prove large enough they could even lead to outright deflation.

However, it is more likely that the impact of these negative shocks will be more than offset by the positive impact of other shocks - for example, rising confidence and domestic demand in Latin America, Eastern Europe and the United States; a gradual recovery in confidence in continental Europe; and the general impact of very expansionary monetary conditions in most corners of the globe. In other words, no systemic fall is likely in aggregate consumer prices.

In judging the relative strength of expansionary and contractionary forces at present, four key points should be made. First, the monetary policy environment is scarcely conducive to global deflation. Growth in nominal GDP in the OECD area is running at around 4 to 4.5 per cent, which is at least 2 per cent higher than would be consistent with global deflation. On Goldman Sachs' indices of global monetary conditions, the major central banks are delivering exceptionally easy conditions at present; the easiest they have been for at least 20 years. Broad money growth is much stronger that the growth in real GDP, suggesting that liquidity is ample. Furthermore, should the growth in nominal GDP falter, there is scope, if necessary, for monetary policy to be eased further in all countries except Japan.

Second, the wealth effects from any likely stock market "crash" from current levels should not prove very significant. At the low point last week, world share prices were still up by about 9 per cent this calendar year, after a 14 per cent rise in 1996. The positive wealth effects from these increases in equity prices have not yet been fully reflected in consumer spending around the world. By the same token, any decline in equity prices from current levels would not depress spending immediately. In fact, after the inevitable near-term confidence effects had been absorbed, consumer spending might continue to rise as a lagged response to earlier increases in equity prices. This, indeed, was one of the lessons of the 1987 crash.

Third, Goldman Sachs has recently carried out some simulations to estimate the impact on the world economy of a much bigger economic shock from Asia than is currently forecast. Specifically, Goldman assumed a slump big enough to trigger an improvement in the current account of 4 per cent of GDP in the Asean countries, 2 per cent of GDP in the rest of Asia and 1 per cent of GDP in Japan. An adjustment of this size would cut 0.4 per cent off the level of US GDP, 0.3 per cent off European GDP and 1.6 per cent off Japanese GDP next year. The overall impact on OECD GDP is about 0.5 per cent - significant but not yet catastrophic. The impact on inflation is also important, but not path-breaking. Assuming a shock of the above magnitude, the world output gap would widen by 1 per cent, curbing world inflation next year by about 0.4 to 0.5 per cent. Nasty for some manufacturing companies, but not the end of the world.

Fourth, this shock occurs at a time when upward revisions to world economic activity in other geographical areas are taking place. The US is now expected to grow by 4 per cent this year, compared with an expectation of 3 per cent a few months ago. There have been modest upward revisions to European growth forecasts. Latin America is expected to grow by 5 per cent this year and next, Eastern Europe by 4 per cent in both years. Even if OECD growth were curbed by 1 per cent next year - an extreme assumption - the world economy would still be a long way from recession.

Importantly, this also seems to be the belief that the global central banks are operating on. While they would certainly be prepared to provide additional liquidity in the near-term in the event of a market meltdown, any easing will prove temporary. On occasions last week, bond markets have flirted with the view that the Fed might shortly be willing to ease policy, and keep rates lower, for several quarters. This is not at all likely.

In summary, Asia is a big place, accounting for about a third of world GDP, and it is suffering a foreign exchange and equity collapse similar to that in Europe in 1992/93. Anyone who thinks that these market shocks will not have severe continent-wide economic effects is clearly out to dinner, as well as to lunch.

But while Asia might be big, the world is a lot bigger - and it is important to remember that the rest of it is doing rather well.

Start your day with The Independent, sign up for daily news emails
PROMOTED VIDEO
ebooks
ebooksA special investigation by Andy McSmith
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

Recruitment Genius: Software Development Manager

£40000 - £50000 per annum: Recruitment Genius: This is an exciting opportunity...

Ashdown Group: Product Manager - (Product Marketing, Financial Services)

£30000 - £35000 per annum + Benefits: Ashdown Group: Marketing Manager - Marke...

Recruitment Genius: Compliance Assistant

£13000 per annum: Recruitment Genius: This Pension Specialist was established ...

Ashdown Group: Market Research Executive

£23000 - £26000 per annum + Benefits: Ashdown Group: Market Research Executive...

Day In a Page

Isis hostage crisis: The prisoner swap has only one purpose for the militants - recognition its Islamic State exists and that foreign nations acknowledge its power

Isis hostage crisis

The prisoner swap has only one purpose for the militants - recognition its Islamic State exists and that foreign nations acknowledge its power, says Robert Fisk
Missing salvage expert who found $50m of sunken treasure before disappearing, tracked down at last

The runaway buccaneers and the ship full of gold

Salvage expert Tommy Thompson found sunken treasure worth millions. Then he vanished... until now
Homeless Veterans appeal: ‘If you’re hard on the world you are hard on yourself’

Homeless Veterans appeal: ‘If you’re hard on the world you are hard on yourself’

Maverick artist Grayson Perry backs our campaign
Assisted Dying Bill: I want to be able to decide about my own death - I want to have control of my life

Assisted Dying Bill: 'I want control of my life'

This week the Assisted Dying Bill is debated in the Lords. Virginia Ironside, who has already made plans for her own self-deliverance, argues that it's time we allowed people a humane, compassionate death
Move over, kale - cabbage is the new rising star

Cabbage is king again

Sophie Morris banishes thoughts of soggy school dinners and turns over a new leaf
11 best winter skin treats

Give your moisturiser a helping hand: 11 best winter skin treats

Get an extra boost of nourishment from one of these hard-working products
Paul Scholes column: The more Jose Mourinho attempts to influence match officials, the more they are likely to ignore him

Paul Scholes column

The more Jose Mourinho attempts to influence match officials, the more they are likely to ignore him
Frank Warren column: No cigar, but pots of money: here come the Cubans

Frank Warren's Ringside

No cigar, but pots of money: here come the Cubans
Isis hostage crisis: Militant group stands strong as its numerous enemies fail to find a common plan to defeat it

Isis stands strong as its numerous enemies fail to find a common plan to defeat it

The jihadis are being squeezed militarily and economically, but there is no sign of an implosion, says Patrick Cockburn
Virtual reality thrusts viewers into the frontline of global events - and puts film-goers at the heart of the action

Virtual reality: Seeing is believing

Virtual reality thrusts viewers into the frontline of global events - and puts film-goers at the heart of the action
Homeless Veterans appeal: MP says Coalition ‘not doing enough’

Homeless Veterans appeal

MP says Coalition ‘not doing enough’ to help
Larry David, Steve Coogan and other comedians share stories of depression in new documentary

Comedians share stories of depression

The director of the new documentary, Kevin Pollak, tells Jessica Barrett how he got them to talk
Has The Archers lost the plot with it's spicy storylines?

Has The Archers lost the plot?

A growing number of listeners are voicing their discontent over the rural soap's spicy storylines; so loudly that even the BBC's director-general seems worried, says Simon Kelner
English Heritage adds 14 post-war office buildings to its protected lists

14 office buildings added to protected lists

Christopher Beanland explores the underrated appeal of these palaces of pen-pushing
Human skull discovery in Israel proves humans lived side-by-side with Neanderthals

Human skull discovery in Israel proves humans lived side-by-side with Neanderthals

Scientists unearthed the cranial fragments from Manot Cave in West Galilee