Inflation – where have you gone? Reply

Inflation – where have you gone?

InflationIt might seem strange to think that anyone could or would ever miss inflation. How can price increases ever be a good thing for a consumer? It means that my meagre monthly income is only able to buy me less bread, milk and beer as the year progresses.

Inflation is the rate of increase in prices for goods and services, and a bit like the famous lyrics of John Mitchell, with inflation “you don’t know what you’ve got till it’s gone”.

Inflation is weighted according to the different goods and services which make up a households expenditure.

Inflation is weighted according to the different goods and services which make up a households expenditure.

Here in South Africa, we have still “got” inflation. Prices are still increasing month by month especially amongst food items (milk, eggs and cheese prices increased by 12% over 2014), alcoholic drinks (Spirits increased by 10.9% over 2014), water services (an 8.5% price increase) and books (an 11.4% price increase over 2014).(For more info see StatsSA). For us, there is no danger (at the moment, and certainly not for the foreseeable future) of a realisation of Mr Mitchells’ song when it comes to inflation. As a result of a growing demand for goods and services, a reliance on imports and thus a weak rand, food price increases, and bottlenecks due to electricity and skilled workers constraints, we can be sure that in SA, inflation will be staying for quite some time. But, don’t be disappointed – consider what happens when inflation, like a friend, disappears.

Inflation rates in the US, EU, UK and China since 2007.

Inflation rates in the US, EU, UK and China since 2007.

That is the situation in the developed world at the moment. In Europe, Britain and the US, inflation has gradually gone away. For a long time, central banks had pursued a steady inflation target of 2%, manipulating the interest rate to try and encourage/discourage investment as need be. However, now, the inflation rate in most of the developed world is below central banks’ target rates.

This low inflation could lead to the dangerous possibility of deflation – where prices no longer increase, but decrease. It might sound like good news for the consumer – surely it is a nice thing if the new car I want to buy is going to be cheaper that what I expected? But just consider some of the other adverse effects: If everyone thinks prices tomorrow, or next week are going to be cheaper than they are today, no one will spend any money but keep delaying and delaying their consumption. Businesses start cutting back on production, profit margins fall. Wages, income and tax revenue stagnate and the real value of any debt grows under deflation. It is something which Japan has had to deal with since 1990.

It is an alarming situation – the increase in uncertainty results in slower growth and can lead to an increase in unemployment. However, there are times when deflation is a result of good things happening in an economy. If companies make productivity gains, and can produce more goods for cheaper, this raises the real income of consumers. Deflation coupled with an increase in output is desirable. Wages do not fall and expectations of profitable business opportunities increase (so more people are willing to borrow money for investment). However, that is not the situation currently seen in the developed countries.

In those countries, due to a variety of reasons as outlined in last week’s post on Secular Stagnation, growth (output) has stalled as these economies face the problem of insufficient demand. There exists an output gap, the economy can supply more goods and services than is demanded at the current price level. This results in businesses and firms cutting prices and wages – which further reduces demand (if your wage falls, you have less income available to purchase goods and services). Debt further aggravates the situation since when prices and incomes fall – the real value of debt rises. You may only owe someone R1000, but now that your wage has fallen to R50, that R1000 becomes more difficult to pay off. So, people are forced to cut their spending habits in order to pay off their debts. But, this means prices continue to fall and we have a deflation spiral!Deflationary Spiral

So what is a solution? Since the interest rate cannot go low enough to stimulate investment and spending, central banks must try to find another solution to tackle the problem of low inflation, and prevent their economies from falling into deflation. If you have been anywhere near news, you will have heard of “Quantitative Easing” – one attempt by Central Banks to increase the money supply and raise prices of financial assets. The US, EU and UK have had QE programs since the recession but inflation rates have remained low. Recently the ECB announced that they would begin a new QE program, purchasing 60bn Euro-bonds per month until September 2016.

An alternative solution would be to focus on fiscal policy. John Maynard Keynes famously proposed that in the face of insufficient aggregate demand, monetary policy is less effective and the government instead should intervene and boost demand. Amidst the low inflation and low interest rates, governments should take the initiative, borrow money and begin spending it. This is similar to the helicopter drop proposal offered by Milton Friedman – where the government should print money and drop it via helicopter around the country. Governments could begin by spending money on more and new infrastructure developments.

What to do in a recession? Rap battle featuring explanation of ideas of two famous economists.

What to do in a recession? Rap battle featuring explanation of ideas of two famous economists.

Politically however, such a move is difficult. How can we allow governments to increase their debt and expenditure when bad debt created the economic crisis? In the US, new government domestic stimulus is vehemently opposed by the Republican Party. In the EU, smaller countries cannot afford to increase government expenditure and larger countries don’t want to. Britain temporarily pursued fiscal expansion until they reverted to austerity measures (prompting a double dip recession) in 2010. Whilst the conservative party remains in the UK government, any new fiscal expansion remains unlikely.

So, perhaps governments in the developed world will continue to use monetary policy in an attempt to stimulate spending – but whilst the demographic problems of low population growth remain, this will result in continued low inflation and slow growth for the foreseeable future. The alternative is the politically dangerous policy of increased fiscal expansion – still taboo today, but if rising unemployment and stagnating prices becomes a reality (as is the situation in Greece) – it may be the only remaining option to increasing overall aggregate demand.

For more reading on deflation – consider this excellent Economist article.

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