http://www.telegraph.co.uk/finance/c...-just-yet.html
Don't write off the deflation danger just yet
Last autumn, when the panic about the world economy was at its peak, one thing which, along with everything else, deeply troubled the markets, was the prospect of deflation, that is to say, a period of falling prices across the economy. This conjured up images of Japan in the 1990s, if not the west in the 1930s. And it was widely recognised that, if it occurred on any scale, deflation would make the plight of the economy worse, as it would increase the real value of debts and cause people to postpone spending.
You could see this fear clearly in market prices. The gap between the yields on conventional government bonds and their inflation-protected (index-linked) cousins gives a measure of the market's expected rate of inflation. At one point towards the end of last year, for five year stocks, in the UK and the US, this gap was negative, indicating that falling prices on average were expected over this period. In France the gap was only about 0.5pc. Now these gaps are back up to about 1.5pc in all three countries. The markets appear to have decided that the deflation scare is over. Are they right?
At one level they appear to be wrong. Last week saw figures from the euro-zone showing inflation falling from 0.6pc to zero. In Germany, inflation dropped from 0.8pc to minus 0.1pc. German inflation hasn't been negative for over twenty years.
This isn't the only area to be experiencing deflation for the first time in recent history. In April headline inflation in the US was minus 0.7pc. Inflation there turned negative back in December – for the first time since 1955.
And deflation is emerging in Asia too. Japan is no stranger to deflation, of course, but now China, Singapore and Taiwan have it too.
The UK inflation experience is a little different from elsewhere. Admittedly, we are already experiencing deflation on the RPI measure, which fell to minus 1.2pc in April. But this measure has been heavily pulled down by falling mortgage interest payments. CPI inflation is still 2.3pc. And although CPI inflation looks likely to fall much further in the coming months, it is looking unlikely that it will actually go negative this year.
So, current UK experience aside, why the insouciance on the part of the markets? They know that these sharp falls in inflation are being driven by the reversal of the rises in food and energy prices that pushed inflation up so sharply over the past couple of years. Once oil and commodity prices stabilise, then however low inflation goes in the short term, it will bounce back to something like its underlying rate.
In fact, oil and commodity prices have even started to reverse some of their recent falls. The oil price last week broke the $60 per barrel barrier for the first time since last November, rising to $63 per barrel. Agricultural commodity prices are also now 25pc above their trough this March. So at some point there could even be another spike in inflation driven by higher commodity and energy prices.
But the markets should also know that dips into deflation caused by sharp movements of commodity prices are not what the real deflation danger is all about. The real risk has always lain with the behaviour of wages. And that danger is still very much alive.
Don't be silly, I hear you say. Earnings are still rising at a relatively healthy clip. In the euro-zone, the annual growth rate of hourly labour costs stood at a robust 3.8pc in Q4 of last year. Admittedly, earnings growth in the US has slowed to a four year low. But annual growth of average hourly earnings in April was still 3.2pc.
However, earnings react to changes in the labour market with a lag. And in the past, when unemployment has risen sharply – as it is doing now – average earnings growth has slowed significantly. In both the US and the euro-zone, it will not be long before earnings growth is close to zero, and quite possibly negative.
This could easily open the door to a far more serious deflation problem. Trend productivity growth in the euro-zone is around 1pc. Even stagnant wages would therefore leave unit wage costs falling by 1pc per annum. In the US, trend productivity growth is rather higher at 2pc to 2.5pc, suggesting that unit labour costs could fall even more sharply there. And unit labour costs are the ultimate foundation for core rates of inflation. If firms' unit labour cost are falling and they are competing for business in a very difficult market then they will cut their prices.
Could it happen here? The main reason for our different inflation experience at the moment is the drop in the pound. This has kept imported food price inflation high and prevented energy prices from falling so much in sterling terms. The behaviour of core inflation in the UK has actually not been that different to elsewhere.
Of course, the pound has recently been creeping up again. It now stands 16pc above its trough against the dollar and up by 10pc in trade-weighted terms. But sterling would have to rise another 25pc or so to get back to the highs reached in 2007. I doubt that it will do this. (I certainly hope not.) But this is not necessary for the relative inflationary effect of the weak pound to fade out over time and for our inflation rate to converge on the core rate.
But what will be happening to the core rate? It all depends upon unit labour costs and the state of demand in the economy. In fact, pay here seems to have responded more quickly to the economic downturn. Average earnings growth actually turned negative earlier this year. Although this was primarily due to the impact of sharply lower bonuses in the City, the figure was also boosted by continued strong pay growth in the public sector. And that can't last. In the private sector not a day goes by without another company announcing a freeze or even a cut in regular pay.
So the upshot is that the deflation danger is not yet old hat. People are watching the wrong thing. Don't look at the short term twitchings of the RPI or CPI but rather at the behaviour of wages and salaries.
Of course, if the Chancellor is right and by the end of this year the economy is bouncing back strongly, then the deflation danger, like all the others, will quickly melt away as the strengthening economy eventually boosts employment prospects, pay rates harden and firms are more able to push prices up. But if you want to back that particular horse, I would strongly advise you to put your money on each way.
Don't write off the deflation danger just yet
Last autumn, when the panic about the world economy was at its peak, one thing which, along with everything else, deeply troubled the markets, was the prospect of deflation, that is to say, a period of falling prices across the economy. This conjured up images of Japan in the 1990s, if not the west in the 1930s. And it was widely recognised that, if it occurred on any scale, deflation would make the plight of the economy worse, as it would increase the real value of debts and cause people to postpone spending.
You could see this fear clearly in market prices. The gap between the yields on conventional government bonds and their inflation-protected (index-linked) cousins gives a measure of the market's expected rate of inflation. At one point towards the end of last year, for five year stocks, in the UK and the US, this gap was negative, indicating that falling prices on average were expected over this period. In France the gap was only about 0.5pc. Now these gaps are back up to about 1.5pc in all three countries. The markets appear to have decided that the deflation scare is over. Are they right?
At one level they appear to be wrong. Last week saw figures from the euro-zone showing inflation falling from 0.6pc to zero. In Germany, inflation dropped from 0.8pc to minus 0.1pc. German inflation hasn't been negative for over twenty years.
This isn't the only area to be experiencing deflation for the first time in recent history. In April headline inflation in the US was minus 0.7pc. Inflation there turned negative back in December – for the first time since 1955.
And deflation is emerging in Asia too. Japan is no stranger to deflation, of course, but now China, Singapore and Taiwan have it too.
The UK inflation experience is a little different from elsewhere. Admittedly, we are already experiencing deflation on the RPI measure, which fell to minus 1.2pc in April. But this measure has been heavily pulled down by falling mortgage interest payments. CPI inflation is still 2.3pc. And although CPI inflation looks likely to fall much further in the coming months, it is looking unlikely that it will actually go negative this year.
So, current UK experience aside, why the insouciance on the part of the markets? They know that these sharp falls in inflation are being driven by the reversal of the rises in food and energy prices that pushed inflation up so sharply over the past couple of years. Once oil and commodity prices stabilise, then however low inflation goes in the short term, it will bounce back to something like its underlying rate.
In fact, oil and commodity prices have even started to reverse some of their recent falls. The oil price last week broke the $60 per barrel barrier for the first time since last November, rising to $63 per barrel. Agricultural commodity prices are also now 25pc above their trough this March. So at some point there could even be another spike in inflation driven by higher commodity and energy prices.
But the markets should also know that dips into deflation caused by sharp movements of commodity prices are not what the real deflation danger is all about. The real risk has always lain with the behaviour of wages. And that danger is still very much alive.
Don't be silly, I hear you say. Earnings are still rising at a relatively healthy clip. In the euro-zone, the annual growth rate of hourly labour costs stood at a robust 3.8pc in Q4 of last year. Admittedly, earnings growth in the US has slowed to a four year low. But annual growth of average hourly earnings in April was still 3.2pc.
However, earnings react to changes in the labour market with a lag. And in the past, when unemployment has risen sharply – as it is doing now – average earnings growth has slowed significantly. In both the US and the euro-zone, it will not be long before earnings growth is close to zero, and quite possibly negative.
This could easily open the door to a far more serious deflation problem. Trend productivity growth in the euro-zone is around 1pc. Even stagnant wages would therefore leave unit wage costs falling by 1pc per annum. In the US, trend productivity growth is rather higher at 2pc to 2.5pc, suggesting that unit labour costs could fall even more sharply there. And unit labour costs are the ultimate foundation for core rates of inflation. If firms' unit labour cost are falling and they are competing for business in a very difficult market then they will cut their prices.
Could it happen here? The main reason for our different inflation experience at the moment is the drop in the pound. This has kept imported food price inflation high and prevented energy prices from falling so much in sterling terms. The behaviour of core inflation in the UK has actually not been that different to elsewhere.
Of course, the pound has recently been creeping up again. It now stands 16pc above its trough against the dollar and up by 10pc in trade-weighted terms. But sterling would have to rise another 25pc or so to get back to the highs reached in 2007. I doubt that it will do this. (I certainly hope not.) But this is not necessary for the relative inflationary effect of the weak pound to fade out over time and for our inflation rate to converge on the core rate.
But what will be happening to the core rate? It all depends upon unit labour costs and the state of demand in the economy. In fact, pay here seems to have responded more quickly to the economic downturn. Average earnings growth actually turned negative earlier this year. Although this was primarily due to the impact of sharply lower bonuses in the City, the figure was also boosted by continued strong pay growth in the public sector. And that can't last. In the private sector not a day goes by without another company announcing a freeze or even a cut in regular pay.
So the upshot is that the deflation danger is not yet old hat. People are watching the wrong thing. Don't look at the short term twitchings of the RPI or CPI but rather at the behaviour of wages and salaries.
Of course, if the Chancellor is right and by the end of this year the economy is bouncing back strongly, then the deflation danger, like all the others, will quickly melt away as the strengthening economy eventually boosts employment prospects, pay rates harden and firms are more able to push prices up. But if you want to back that particular horse, I would strongly advise you to put your money on each way.
I'm not Koncerned.
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