Don’t fear the deflation bogeyman: It’s unlikely to harm the UK economy
As flat as a pancake. Last week’s inflation figures showed that the Consumer Price Index (CPI), the main measure of the prices of goods and services bought by households, was the same in February as it was a year earlier. This has led many to ponder the likely economic implications of deflation – if the UK experienced a period of the CPI falling.
This now looks very possible. Cheaper oil and food prices have been primarily responsible for dragging down the aggregate index. Excluding them and other volatile items, the so-called “core” rate of inflation was 1.2 per cent in February. But one could well imagine a situation in which the falling costs of inputs, particularly motor fuels, are passed through in other price reductions such that the index actually falls in the coming months.
Most mainstream economists believe this would be transitory (just as higher inflation in 2011 was), and see current low inflation as unalloyed good news. After all, it appears to be driven in large part by a significantly increased oil supply. Yet for others, deflation has taken on a “bogeyman” status – with some invoking the Great Depression in the US, when prices fell by 24 per cent.
Given the historical record, this fear seems irrational. The Great Depression (in the US at least) was certainly a period of accelerating deflation and large contractions in economic output. But this doesn’t mean that falling prices need always reflect contractions in aggregate demand. Indeed, there were other long periods of deflation in the nineteenth century when output increased. Very basic economics can explain falling prices through increases in supply that also boost output – whether through productivity improvements, or more competitive product markets.
In short, falling prices can be a symptom of good or bad economic developments. But deflation, like inflation, might also have its own effects on the economy’s health. In other words, there could be mechanisms through which falling prices harm the economy – including the supposed “debt-deflation” spiral, whereby debts increasing in real terms induces defaults and spending cuts. Whether deflation tends to be reflective of, or harmful towards, economic growth is therefore ultimately an empirical question.
The Bank for International Settlements (BIS) recently published a study testing the link between growth and deflation by examining 38 countries over 140 years. The results are striking. BIS finds little evidence of lower output growth being associated with falling prices, except in the Great Depression. In fact, for the post-war period, it finds that growth was actually higher in years that saw falling prices. What BIS does find, however, is that asset price deflations – particularly property prices – are associated with slower growth.
Once one controls for these and other country-specific effects, even persistent deflations in the prices of goods or services do not seem to be associated with slower growth, including during the period in which the Great Depression occurred. Nor do falling consumer prices, as opposed to asset prices, seem to interact with high debt levels to adversely affect the economy in the way that those who worry about “debt deflation” suspect.
So given the historical evidence, those who invoke the deflation bogeyman today are required to jump a pretty high evidence hurdle to convincingly argue that falling prices are symptoms of substantial economic problems which could have highly harmful effects in the future. Deflation can be good or bad, transitory or persistent. But in the current circumstances, it seems any near-term contraction of the CPI would be benign.