5 February 2009
The Deflation Debate: Myth and Reality
The following article was written by Peter G. Hall, Vice-President and Chief Economist, Export Development Canada.
Concern about deflation is gathering momentum. The dreaded ‘d’ word surfaced last fall, and is now a regular in business news. It has even crept into emerging market analysis, unimaginable just weeks ago. Are we really on a deflation precipice, or is this just headline-grabbing alarmism?
Recent data are fuelling the deflation debate. Price growth is getting razor-thin in the world’s major economies, and in some cases annual consumer price increases are negative. Moreover, consumer price growth has stalled almost overnight. Recall that just six months ago, central banks the world over were fretting about runaway prices. On the surface, things look pretty grim.
From this perspective, things will only worsen in the coming months. Take Canada, for example, where CPI growth fell from 3.5% last August to just 1.2% in December. The recent monthly movements that have reduced yearly growth so rapidly virtually assure that we will see outright declines in CPI for quite a few months in the middle of this year. This will occur whether monthly growth is in line with the Bank of Canada’s inflation target or not. At that time those who heralded deflation’s imminence will likely proclaim its arrival with much fanfare. Are they right?
Whether or not they are right, they’ll have lots of company. The same phenomenon is already suppressing headline prices in most large nations, sparking the same debate. Eurozone price growth, at 4% in July, is now 1.6% and falling. UK CPI growth was 5.2% in September, and is now 3.1%. US CPI growth has tumbled even more dramatically, from 5.5% in July to -0.1% in December. In each case, the negatives are bound to deepen in the coming months. Anecdotal evidence suggests that even emerging markets won’t dodge the drop. But is it actually deflation?
Simply put, no. Price gyrations over the last year – both up and down – were heavily influenced by wild swings in food and energy prices. Fears of shortages hit both sectors early last year, and prices spiked. Those fears vapourized in the second half of the year as growth slowed, and prices plunged. The fact is, take away these sectors, and CPI growth everywhere is remarkably stable. Core inflation – the measure that removes volatile commodities – is in line with pre-set targets.
True deflation is far more than mere specific commodity price movements. It permeates into most aspects of the economy, triggered initially by the unwinding of excessive debts that piled up in the good years, and producing declines in the prices of a broad range of goods and services. It is truly rooted in an economy when the general public becomes convinced that price declines are the norm. When this occurs, consumers hoard their cash for as long as possible, knowing that purchases will be cheaper the longer they can delay them. Businesses do the same. Wages are the next to decline, and at this point the psychology of deflation becomes very difficult to dislodge. Deflation is a risk for 2009, but at the moment we are a long way from that point. To get there, today’s gloomy consumers would have to make a psychological leap that presently looks unlikely.
The bottom line? Today’s talk is more sensation than deflation. Recent aggressive and globally coordinated policy actions are aimed at nixing the fear factor that brings on real deflation. But given current market jitters, careless analysis could undo those best efforts.