December 1, 2008 | posted by Michael Baxter in inflation | comments (0) |

There aren’t many hawks left these days. Time was when the central bank dovecote, was all but empty, and the hawks looked down from their lofty perch upon the economic terrain and made all kinds of squawks about the threat of inflation.

Well, in the US, they turned tail months ago. In the UK, the last few months seemed to see something of a hawk purge. But in the Eurozone, the hawks still seemed to dominate the sky, at least until very recently. In fact, incredibly, the European Central Bank voted to up rates to 4.25 per cent only in July.

But then, Friday saw the most dramatic news yet to suggest that has all changed. The stage is now set for big cuts in the Eurozone rate of interest, as the Bank of England and European Central Bank join a race to zero rates.

But dig a little deeper, and you find that the real forces that are at work are quite different from what you might expect.

In the Eurozone, inflation, as measured by the consumer price index, fell from 3.2 to 2.1 per cent. That’s a massive drop.

The index is now at its lowest level in 14 months, and just 0.1 per cent above the target rate.

At the time of writing, data was not available to show how the inflation figures break down, but one assumes falling food and oil were behind the declining index.

It seems the index is set to fall even further over the next few months.

You may know that Mervyn King, the Governor of the Bank of England, expects negative inflation as measured by the retail price index next year, and says there is a possibility of negative inflation as measured by the consumer price index.

For some time now, it has been argued here that this analysis is wrong.

Falling asset prices, falling credit availability and slumping demand mean prices are set to fall, and then fall some more.

And yet, ironically, maybe we will see a reverse of the conditions seen earlier in the decade.

Back then, asset prices soared, and food and energy costs went up. Other products, especially products imported from China, fell in price. So, for example, we had cheap furniture. It is possible that the next few years will see the opposite.

In the UK, the falling pound is making imports more expensive. In China, reports talk about factories closing and unemployment mounting. In the UK, the closure of MFI, and no doubt other furniture retailers will follow suit, may eventually lead to a shortage of furniture stores. Maybe the products that fell in price earlier this decade, will rise in price moving forward.

If this economic cycle proves to be symmetrical, then expect a funny kind of deflation moving forward.

There are two dangers with deflation. One is that falling prices mean we put off our spending, but it often seems that this is an exaggerated danger. People can’t put off their expenditure indefinitely. As for non discretionary items, such as food and petrol, there is hardly any option to delay expenditure at all.

The real danger lies with wage deflation. Employers may respond to falling demand and increasing looseness in the labour market by cutting wages. And this is the real dilemma.

Time was when economists used to argue that unemployment shouldn’t exist. They said wages were determined by demand and supply for labour. Supply was fixed, so, therefore, wages would sit at that level required to ensure there was no unemployment.

It was Keynes who spotted the flaw in that argument. If wages are falling, he argued, demand would fall too, leading to more job losses and a rather nasty downward spiral.

This is less of a danger in the Eurozone, where the labour market is inflexible. The minimum wage and union intransigence will surely reduce the danger of falling wages. In the Eurozone, sharply rising unemployment is more likely to be the result of falling demand.

In the UK, wage deflation is a more serious threat.

But then if it comes down to a choice between unemployment and wage deflation – it is difficult to know what to do.

It seems, however, that if deflation really does occur, governments via central banks do have one more weapon left in their armoury – there is always the printing press. There is the option of central banks lending to banks with negative interest rates – or through unfunded tax cuts.

You can’t do this, of course. We all know that if the government prints more money – inflation mounts. But if deflation is the danger, surely that is the right thing to do.

Except this. All that extra money the central banks create will not go away, and could leave an inflation legacy for years.

But, and this is where the opinion expressed here is unusual, there is another way of looking at this.

The last ten years or so have seen global capacity shoot up; this was caused in part by globalisation, in part through improving technology – although the improving technology also helped promote globalisation so, in a way, the surge in capacity is solely down to improving technology.

Under those circumstances it is right to increase the money supply.

In the days before the Industrial Revolution, the money supply was determined by the amount of gold that was in existence. In that era, innovation had to mean deflation. The finding of gold in the New World, and the development of banks and credit, surely underpinned the Industrial Revolution.

There is a good TV programme on at the moment – The Ascent of Money by Niall Ferguson. He shows how the growth in the banking sector created much of today’s wealth. At some stage during the series – it may be tonight’s episode – he will argue that the Mississippi Bubble in France 250 years or so ago, led to greater suspicions of debt-based economic systems in that country. He argues that is why the Industrial Revolution occurred in Britain and not in France.

We are of course seeing manifestations of that belief today, whenever Nick Sarkozy criticises the Anglo-Saxon banking model.

Ultimately, though, the crisis we are seeing today was not caused by silly bankers or booming house prices; it was not even caused by a lack of balance with some countries saving too much and others saving too little. These are surely symptoms of a deeper force at work. This deeper force is surely the mismatch between demand and supply, caused by rising global productivity.

When was the last time we had such a mismatch? – well, it may well have been the 1930s.

November 11, 2008 | posted by Michael Baxter in inflation | comments (0) |

Falling over the edge of a cliff is usually thought of as a bad thing. It is usually bad when applied to the economy, too, but not this time. For once, a major crash in an index is very good news indeed.

Manufacturing is not the most exciting thing to read about. Normally, of course, news from our manufacturing sector is so bad that it is difficult to feel excited about any development in the sector.

But then, this morning probably saw about the best bit of news we have seen on this sector for …, well, for a very long time.

Producer prices are crashing.

You probably know there are two headline indexes relating to producer costs. There’s input prices, which are what manufacturers pay to their suppliers, and there’s output prices, which provide an indication of what manufacturers charge their customers – which more often than not are the retailers, who then sell on to us.

Input prices fell 2.4 per cent in October, against the previous month. Just to emphasize that, prices fell by 2.4 per cent in just one month.

Output prices fell 0.5 per cent in the month.

The annual rates of input and output prices are both still well into double figures, of course, but the two indices are falling rapidly.

The annual rate of output prices fell from 8.5 to 6.8 per cent from September to October. But the point is, this index had been falling rapidly anyway. Back in July, for example, annual output prices inflation was 10 per cent.

As for annual input prices, they were down to 13.8 per cent, from 24 per cent in September and 31.3 per cent in July.

Of course, 12 months’ worth of data make up the annual figures, and it takes 12 months before regular monthly falls show their maximum impact. But so rapid are the falls in the monthly index, that Capital Economics reckons that even if we see no further falls in the price of oil, we will still see negative producer prices inflation early next year.

It’s god news all around. It will only be a matter of time before the big falls in manufacturing prices translate into cheaper goods on the High Street.

As for manufacturing, the big boost will come when output inflation starts exceeding input inflation. For too long, manufacturers have been swallowing the bulk of surging bills from their suppliers.

The data on manufacturing shows unequivocally why wider inflation is set to fall sharply, and why it has been predicted here for some time that, within a year or so, consumer price inflation will go negative.

The next few years are going to be tough, but falling prices means those who hold on to their jobs will find every penny they earn will stretch a good deal further. This will provide the seeds for economic recovery.

November 6, 2008 | posted by Michael Baxter in inflation | comments (0) |

First it was oil, now it’s the goods we buy on the High Street.

It’s funny. While all around doom and gloom is the staple diet, the best bit of economic good news we have received for a very long time has barely been noticed.

The latest data out from the British Retail Consortium (BRC) revealed that both food and non-food inflation turned negative in October.

The annual figures are still well into positive territory, of course, with the BRC recording the annual rate of food inflation at 7.5 per cent. Non-food annual inflation stands at 0.7 per cent and the combined rate at 3 per cent.

But you need to bear in mind, 12 months’ worth of data make up the annual figures and, therefore, it takes a year before changes work their way out of the system.

Annual food price inflation peaked in August, hitting 10 per cent, whereas month on month food inflation peaked in the previous month when prices rose by 1.9 per cent in just the one month.

But ever since then, the trend has been down. Food inflation rose by just 0.3 per cent in August and turned negative in September.

But October was the first month which saw negative month on month food and non-food inflation for a very long time. Overall, prices were down 0.1 per cent in the month, the first fall this year.

But, expect the decline to accelerate. We could be just six months or so away from seeing the annual rate of food and non-food inflation go negative.

That the next year or so is going to be tough, is patently obvious. But for those who can hold on to their jobs, affordability is set to improve significantly. Every penny will stretch a lot further.

Falling food and oil prices will also afford the Bank of England greater leeway in cutting interest rates – of course. By the time you read this, you will probably know how much the Bank of England has chosen to cut interest rates.

The time is now right to cut rates in a big way. The UK’s central bank could easily justify knocking 1.5 percentage points off interest rates. It probably won’t, a half a per cent is far more likely, given the bank’s usual cautious approach. In any case, the full extent of rate cuts won’t be passed on by the banks. But the trend is clear. Interest rates, and in turn the monthly amounts mortgage holders have to fork out for their payments, are all set to fall.

And as inflation turns, deflation, which we have been predicting for much of this year, is beginning to make its mark.

Bear this in mind. Even when the economy was booming, there was plenty of evidence to suggest our discretionary disposable income – that is, net income after things we have no control of, such as council tax, mortgage payments/rent, utility bills and the cost of travel to work – was shrinking. Truth is, even when the economy was booming, we were getting worse off.

It seems strange, given the way affordability was being squeezed, few economists predicted problems ahead.

Well, now affordability is set to loosen.

This is how the economic cycle works. When times are good, we spend too much, prices are forced up, our affordability is squeezed. Then it goes into reverse. The pattern is as old as the hills.

The exposure lies, of course, in that balance between falling prices and rising unemployment. The danger lies in the possibility that, as prices fall, we save the difference. This in turn will lead to falls in aggregate demand, and a downward spriral could then follow.