The European Central Bank might like to update its website – specifically, its educational video to teach teenagers about the importance of keeping prices in check.
In it, a spotted, fanged, snarling “inflation monster” floods money into the marketplace, making vivid the perils of prices rising too quickly. Near the end of the cartoon a much smaller, smiling, pink creature makes a brief appearance – the “deflation monster”.
Fear of inflation is understandable in a continent that saw devastating hyperinflation last century – a shock seen by some as pivotal in the rise of Hitler. But look around the eurozone now and the bigger threat is deflation.
Even in the UK, inflation is well below the Bank of England’s target and the central bank expects it to fall further over coming months. Oil prices have been falling, as have other commodity prices. In Britain a supermarket price war is pushing food prices down further still. Wages are barely budging and a price freeze for energy bills should also help to keep inflation low this winter. The Bank fully admits it failed to forecast this significant drop below the government-set 2% target for inflation.
Governor Mark Carney used the Bank’s latest forecasts earlier this month to warn of “some pretty big disinflationary forces”, largely coming from abroad. He predicted inflation would fall even further, to below 1% over the next six months. If it does, he will face the unenviable task of being the first governor since BoE independence in 1997 to write a letter to the chancellor explaining why inflation is so low. All of the 14 letters written until now have been because inflation missed the target too far in the other direction, overshooting by more than 1 percentage point.
Aside from the awkwardness of the Dear George moment, there are very real reasons why Carney is saying the Bank needs to get inflation back to target. The inflation monster may be scary, but the deflation monster is by no means harmless.
Even low inflation can be damaging, particularly if it breeds the expectation that outright deflation will follow. If people expect prices to fall, they are encouraged to hold off spending. Economic stagnation and rising unemployment can follow.
For retailers, this is all spelling Christmas doom. Already the runup to the most crucial time of the year for shops is being characterised by a game of chicken. Shoppers are wondering how long they can leave their festive buying in the hope of late bargains. Last week’s official retail sales figures, which measure volume rather than value, painted a picture of lots of shopping but at low prices. Margins are being squeezed and we should not be surprised to see some Christmas casualties on the high street.
Low inflation is also a problem for those with debts. Unfortunately, at the moment that means a vast number of households and governments, too. Low inflation makes the value of someone’s debt fall more slowly than they had anticipated. For governments, the income to tackle those debts is dented as tax receipts slow.
There is an additional headache for policymakers, as low inflation raises interest rates in real terms. With rates very close to zero already there is little room left for the BoE and its counterparts elsewhere to do much to stimulate inflation.
The Bank’s deputy governor, Jon Cunliffe, highlighted this sticky position in a recent speech. While two of his colleagues on the Bank’s nine-strong rate-setting committee have consistently voted to lift rates, Cunliffe is clearly in the holding-off camp.
His explanation sums up the trade-off faced by central bankers: “With the scope for tightening monetary policy substantial, but the scope for loosening it much more limited, the risk of a surprising pick-up in inflationary pressure may be more manageable than the risk of the expansion stalling and inflation dropping further.”
Of course, there is a silver lining. As inflation comes down, and the value of money decreases at an ever slower pace, savers and pensioners benefit. Real wages may eventually start to rise, ending the biggest pay squeeze in decades. But is dangerously low inflation really the way we want to achieve real wage growth?
That may not be how things play out. In the longer term, inflation could go either way – the Bank can see arguments to support contrary forecasts, for a fall as well as a rise. It could be that the slack in the economy will be used up faster than it expects and inflation end up going over 2%. At the same time, there is a risk growth might soften more than anticipated and inflation stay below target for longer than expected. With previous forecasting failures at the front of their minds, policymakers are careful not to say which is more likely.
That same record on forecasting, and the Bank’s contrition, has been behind a change that is welcome to those of us worrying that the little deflation monster had been forgotten. Andy Haldane, the Bank’s chief economist, went so far as to announce a “cultural revolution” at Threadneedle Street last week. He was unveiling plans for future research that “challenges the policy orthodoxy as often as supports it”. Haldane sees this as a crucial way to ward off the kind of “groupthink” that led to blind spots among economists and policymakers in the runup to the financial crisis. Let’s hope it heralds more work on falling prices, and gives inflation warriors everywhere something to think about.
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