At times of economic crisis, the price level in an economy becomes a weather vane: what really matters is the direction it is pointing. And at the moment the economic indicators for the British economy are pointing, ominously, towards deflation. Yesterday’s Consumer Price Index from the Office for National Statistics showed a smaller than expected decline last month, from 3.1 per cent to 3 per cent. But this modest fall was probably down to the reluctance of many retailers to repeat their heavy pre-Christmas discounting.
The overall trend for prices in recent months is still sharply downwards. This is unlikely to change as long as companies are shedding jobs, consumer demand is shrinking and energy prices are dropping. Last week, the Bank of England forecast that the CPI would drop below its target rate of 2 per cent in the coming months and remain there for two years. The Retail Price Index, a measure of inflation which includes housing costs, is already brushing zero and will almost certainly turn negative this year.
There is a strong temptation, with memories of painful inflation still strong in the collective consciousness, to regard a period of falling prices as a breath of fresh air, yet that would be a grave mistake. Sustained and high deflation is just as poisonous for an economy as sustained and high inflation.
History teaches that, if deflation is allowed to take hold, shoppers tend to delay non-essential purchases in the rational expectation that goods will get cheaper in the future. This undermines companies’ earnings, forcing them to shed staff. And an increase in unemployment sucks further demand out of an economy.
For countries such as Britain with relatively high levels of household debt, deflation is particularly harmful. In a period of falling prices, the real value of that debt burden actually grows and so does the cost of servicing it. During the Great Depression of the 1930s, this process was described by the US economist Irving Fisher |as “debt deflation”. We could well be in line to experience another unpleasant dose.
The Bank of England is adopting measures to counter the threat of deflation, cutting interest rates and preparing to inject more money into the economy to support prices if necessary. The US Federal Reserve is taking the same action to counteract similar deflationary forces acting within the world’s largest economy.
The good news is that the world’s monetary authorities should, with sufficient determination, be able to fend off deflation. The bad news is that it will be extremely difficult for them to deal with the inflationary pressures generated in the process.
Central banks would have to take contentious and painful measures to halt an inflationary spiral when economic activity eventually picks up. The Bank of England, unlike the Federal Reserve, does not control a global reserve currency. This means it would have to be particularly quick to apply the monetary brakes or a sterling rout could be in prospect. The budget deficits that the British Government plans to run over the coming years will also make the job of maintaining confidence in the currency very difficult.
But this is a matter of priorities. Our monetary authorities and political leaders must concentrate on the most significant threat before them. And, the way the economic wind is blowing, the immediate danger is a prolonged slump accompanied by destructive deflation.