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Negative thinking

28 April 2015

While deflation is feared by financial leaders, could it actually be beneficial to an economy in the short term?

Christine Lagarde, the International Monetary Fund’s managing director, called it an ‘ogre stalking the world economy’. Bank of England (BoE) Governor Mark Carney said it would be ‘unambiguously good’ for the UK, at least for a time. Whoever is right, and they may both be, deflation has been moving closer to reality for the British economy.

Inflation, as measured by the Consumer Prices Index, fell from 0.5% in December to 0.3% in January, and then further to 0% in February1. This was its lowest level since comparable records began in 1989. The biggest influences were falling fuel and food prices. The BoE’s target level is 2%. Since the outcome missed the target by a margin of more than 1%, Governor Carney was obliged to write a letter to the Chancellor of the Exchequer, explaining why.

The letter wasn’t his first, and it won’t be his last. Most economists now think that inflation will dip below zero, thereby becoming deflation, for at least a brief period. The last time that happened here, albeit using a different measure, was in 1960. We should all hope it is short-lived, as classic and prolonged deflation can be an ugly phenomenon.

Carney certainly expects inflation to fall further. He said it would ‘potentially turn negative in the spring and be close to zero for the rest of the year’. But while deflation is a bogeyman for most economists, he has been relatively upbeat about the prospect.

‘The combination of rising wages and falling energy and food prices will help household finances and boost the growth of real take-home pay this year to its fastest rate in a decade,’ he told reporters. ‘This will support solid growth in consumer spending.’ He sent an unambiguous message that the next move in the interest rate, that has been at 0.5% since March 2009, would be upwards, although a move is not imminent.

We have all been enjoying cheaper petrol, the result of significantly lower prices in the international oil market. This has fed through into lower costs for manufactured goods, food and imports in general. Supermarket competition has been driving food prices down further. If we are feeling the pinch less, we may be more inclined to spend on other things, as Carney suggested.

But falling prices become more pernicious over a sustained period. People postpone buying goods, particularly big-ticket items, because they know they will be cheaper tomorrow. Companies are forced to cut prices, so they put off investment and recruitment. Unemployment rises. With wages stagnating, consumers spend even less. Government tax receipts suffer. Debt becomes even more burdensome, because every pound that is repaid is worth more than the pound that was borrowed. That applies equally to individuals, companies and governments.

This pattern is what was seen in Japan in the late 1990s, after that country’s prolonged boom had turned to bust. Its economy has been in a state of deflation and has suffered stagnation for most of the time since then. With the help of Prime Minister Shinzo Abe and his ‘Abenomics’ policies, however, inflation and growth have recently returned to the Japanese economy.

Prolonged deflation changes the game for investors. In equities, they need to be more selective. Companies will find it much harder to grow, so big blue-chip stocks with pricing power and resilience will become even more attractive. Those in defensive industries or monopoly markets will be in demand, as will the willingness and capacity to keep paying dividends. Investors will also be looking for high-growth smaller businesses that are more nimble and innovative than their bigger brethren.

Deflation enhances the attraction of fixed-rate bonds as the real return, that is adjusted for inflation, becomes more valuable; so yields on triple-A sovereigns and high-quality corporate bonds could shrink even further.

The fact that deflation causes asset prices to fall and debts to become more onerous means it can detract from investment in property. That would typically involve committing to long-term debt, to be paid off in increasingly valuable pounds, for an asset whose own value will depreciate – not only buy to let, but commercial property, too. In the same spirit, if a deflationary environment is a bad time to borrow over the long term, it’s a good time to pay off your debts. The fact remains, however, that deflation is usually more talked about than real. The IMF’s Lagarde is correct to describe it as an ogre, but BoE Governor Carney is probably also on the mark when he says it won’t be around long enough to do any harm.

Remember that inflation and deflation describe the movement of prices over a period of time. The biggest driver behind the present fall in inflation has been the drop in oil prices. But they are unlikely to fall much further, if at all, and have in fact recovered slightly from their January lows. So while the price of oil may remain low, its deflationary power may be all but spent.

The last major deflation was during the Great Depression of the 1930s. Then the US Federal Reserve made the (deflationary) mistake of limiting the money supply. Today, the world’s central bankers have headed in the opposite direction with quantitative easing which, since it is effectively printing money, is inflationary.

Pavilion Global Markets, a Canadian firm, recently updated an earlier IMF study into just how prone major economies were to deflation. The answer was less than they were in 2003, or even in 20092. ‘In the world,’ its authors concluded, ‘the risk of deflation is considered low.’

1 Office for National Statistics

2 www.bloomberg.com

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