http://www.telegraph.co.uk/finance/c...lation-is.html
Spring is sprung, green shoots are riz; I wonder where inflation is?
Spring has come and green shoots have been sprouting. Certainly recent stock market performance suggests that someone thinks that recovery is just around the corner. In particular, the widespread gloom about the financial system has largely dissipated.
Spring has come and green shoots have been sprouting. Certainly recent stock market performance suggests that someone thinks that recovery is just around the corner. In particular, the widespread gloom about the financial system has largely dissipated.
One aspect of this changed mood has been a change of view with regard to the chances of deflation. Towards the end of last year there was real fear in the market that we would experience a bout of deflation, perhaps akin to what was experienced in Japan in the 1990s, which would deepen the downturn and make the recovery process more difficult. Now there is much greater confidence that this danger has been avoided. Indeed, for many market operators, the more pressing fear is a surge of inflation. Are they right?
The main reason for the change of view has been what has happened to the inflation figures themselves. The official targeted measure, CPI inflation, has fallen only very gradually and still stands at 2.9pc, well above the 2pc target. This is in marked contrast to what has been happening elsewhere. In the Eurozone, headline inflation was 0.6pc in March compared to 3.6pc a year before. In the US, consumer price inflation dipped into negative territory in March for the first time since 1955, dropping to -0.4pc. I reckon that inflation in the US could fall as low as -2pc by the summer.
The fundamental reason for the contrast between inflation here and inflation abroad is surely what has happened to the pound, which is down by roughly 25pc. This has hugely increased the price of imports and thus imparted an inflationary push. As long as the pound stays down, this factor is likely to keep UK inflation higher than inflation abroad.
But it would be a serious mistake to assume that the deflation danger has gone away. As it is, on the wider RPI measure, UK inflation is currently minus 0.4, and this measure could go as low as minus 3pc this autumn. Even CPI inflation will continue to fall, perhaps reaching 0.5pc or so in the autumn.
In any case, I never thought that this was the year when the deflation danger would manifest itself properly. The sharp falls in inflation this year have been caused by one-off factors, principally the contrast between the falls in oil and commodity prices over the last year with the larger rises over the previous year. In the UK, this has been exacerbated by the cut in VAT. It always seemed likely that the inflation numbers would bounce back into the positive next year.
I always thought that the big issue that would determine whether low inflation became established as a new trend or whether the deflation danger emerged properly was the behaviour of wages and salaries. And what has happened in the UK has been astonishing. Nominal annual earnings growth (including bonuses) fell to -2.1pc in February.
Now admittedly these figures are heavily influenced by the collapse of bonuses in the financial sector. But even excluding these, the rate of increase of average earnings has fallen to 2.9pc. And the position is more striking if you strip out the public sector, which have sailed on regardless. Over the year to February, including bonuses, private sector pay fell by 2.8pc.
What's more, with unemployment looking set to rise to 3.5 million or so by the end of 2010, and with price inflation in the shops falling to close to zero on the CPI measure, and negative on the RPI measure, downward pressure on pay can only intensify.
There is widespread incredulity about the idea that pay inflation in Britain could get stuck at about zero. It is ingrained that pay here rises at 3-5pc per annum. But in fact, as our chart shows, pay has only increased regularly at this fairly modest rate since 1992. From then to now the average rate of increase of pay has been 4pc per annum. But over the previous period back to 1981 the norm was 8.5pc. And before that, the rate was much higher. The last two deep recessions have shifted the rate of pay inflation down, and once the recession has ended, pay has increased at the new subdued rate. I reckon that this could happen again now, with the new norm being zero.
There is talk that a new Conservative government would impose a public sector pay freeze. If that happens it would help to keep pay rises low in the private sector as well. Static pay in the private sector would have powerful implications. Normally productivity growth is about 2pc per annum. So if pay is static that means that unit labour costs will be falling by about 2pc per annum – and that, other things equal, would validate a rate of price deflation of 2pc per annum.
Of course, all other things aren't equal. For a start, during the downturn, productivity growth will not be 2pc. For a time it may well be negative. Also, even if unit labour cost growth is negative, firms won't want to cut prices, but will rather try to maintain them and so widen their profit margins.
Still, these factors are only transitional. Once the economy stabilises, the rate of productivity growth will pick up. Meanwhile, with substantial excess capacity in the economy, firms will be fighting for market share. So competitive forces will beat prices down. And eventually the inflationary effects of the lower pound will fade.
So what of the fears of inflation stalking the market? There is no doubt that the policy of quantitative easing has the whiff of inflation about it. Yet this will only cause inflation if the increased liquidity is not mopped up by reversing the policy once the economy starts to recover.
What looks like happening to wage inflation suggests to me that, if things go well, once the recovery comes, it will do so with inflation very low indeed, thereby giving the authorities some leeway to reverse quantitative easing before any surge of inflation gets going.
If things go badly, however, as the reality of zero inflation/deflation grinds away, then the expectation that this is the new norm will become ingrained, and this will make it more difficult for quantitative easing to have much effect. Either way, I reckon that there are many more years of low inflation still to come.
Spring is sprung, green shoots are riz; I wonder where inflation is?
Spring has come and green shoots have been sprouting. Certainly recent stock market performance suggests that someone thinks that recovery is just around the corner. In particular, the widespread gloom about the financial system has largely dissipated.
Spring has come and green shoots have been sprouting. Certainly recent stock market performance suggests that someone thinks that recovery is just around the corner. In particular, the widespread gloom about the financial system has largely dissipated.
One aspect of this changed mood has been a change of view with regard to the chances of deflation. Towards the end of last year there was real fear in the market that we would experience a bout of deflation, perhaps akin to what was experienced in Japan in the 1990s, which would deepen the downturn and make the recovery process more difficult. Now there is much greater confidence that this danger has been avoided. Indeed, for many market operators, the more pressing fear is a surge of inflation. Are they right?
The main reason for the change of view has been what has happened to the inflation figures themselves. The official targeted measure, CPI inflation, has fallen only very gradually and still stands at 2.9pc, well above the 2pc target. This is in marked contrast to what has been happening elsewhere. In the Eurozone, headline inflation was 0.6pc in March compared to 3.6pc a year before. In the US, consumer price inflation dipped into negative territory in March for the first time since 1955, dropping to -0.4pc. I reckon that inflation in the US could fall as low as -2pc by the summer.
The fundamental reason for the contrast between inflation here and inflation abroad is surely what has happened to the pound, which is down by roughly 25pc. This has hugely increased the price of imports and thus imparted an inflationary push. As long as the pound stays down, this factor is likely to keep UK inflation higher than inflation abroad.
But it would be a serious mistake to assume that the deflation danger has gone away. As it is, on the wider RPI measure, UK inflation is currently minus 0.4, and this measure could go as low as minus 3pc this autumn. Even CPI inflation will continue to fall, perhaps reaching 0.5pc or so in the autumn.
In any case, I never thought that this was the year when the deflation danger would manifest itself properly. The sharp falls in inflation this year have been caused by one-off factors, principally the contrast between the falls in oil and commodity prices over the last year with the larger rises over the previous year. In the UK, this has been exacerbated by the cut in VAT. It always seemed likely that the inflation numbers would bounce back into the positive next year.
I always thought that the big issue that would determine whether low inflation became established as a new trend or whether the deflation danger emerged properly was the behaviour of wages and salaries. And what has happened in the UK has been astonishing. Nominal annual earnings growth (including bonuses) fell to -2.1pc in February.
Now admittedly these figures are heavily influenced by the collapse of bonuses in the financial sector. But even excluding these, the rate of increase of average earnings has fallen to 2.9pc. And the position is more striking if you strip out the public sector, which have sailed on regardless. Over the year to February, including bonuses, private sector pay fell by 2.8pc.
What's more, with unemployment looking set to rise to 3.5 million or so by the end of 2010, and with price inflation in the shops falling to close to zero on the CPI measure, and negative on the RPI measure, downward pressure on pay can only intensify.
There is widespread incredulity about the idea that pay inflation in Britain could get stuck at about zero. It is ingrained that pay here rises at 3-5pc per annum. But in fact, as our chart shows, pay has only increased regularly at this fairly modest rate since 1992. From then to now the average rate of increase of pay has been 4pc per annum. But over the previous period back to 1981 the norm was 8.5pc. And before that, the rate was much higher. The last two deep recessions have shifted the rate of pay inflation down, and once the recession has ended, pay has increased at the new subdued rate. I reckon that this could happen again now, with the new norm being zero.
There is talk that a new Conservative government would impose a public sector pay freeze. If that happens it would help to keep pay rises low in the private sector as well. Static pay in the private sector would have powerful implications. Normally productivity growth is about 2pc per annum. So if pay is static that means that unit labour costs will be falling by about 2pc per annum – and that, other things equal, would validate a rate of price deflation of 2pc per annum.
Of course, all other things aren't equal. For a start, during the downturn, productivity growth will not be 2pc. For a time it may well be negative. Also, even if unit labour cost growth is negative, firms won't want to cut prices, but will rather try to maintain them and so widen their profit margins.
Still, these factors are only transitional. Once the economy stabilises, the rate of productivity growth will pick up. Meanwhile, with substantial excess capacity in the economy, firms will be fighting for market share. So competitive forces will beat prices down. And eventually the inflationary effects of the lower pound will fade.
So what of the fears of inflation stalking the market? There is no doubt that the policy of quantitative easing has the whiff of inflation about it. Yet this will only cause inflation if the increased liquidity is not mopped up by reversing the policy once the economy starts to recover.
What looks like happening to wage inflation suggests to me that, if things go well, once the recovery comes, it will do so with inflation very low indeed, thereby giving the authorities some leeway to reverse quantitative easing before any surge of inflation gets going.
If things go badly, however, as the reality of zero inflation/deflation grinds away, then the expectation that this is the new norm will become ingrained, and this will make it more difficult for quantitative easing to have much effect. Either way, I reckon that there are many more years of low inflation still to come.
