Consumer prices in Ireland fell by 0.3% in the year to December, providing a welcome boost to the real income of Irish households. Prices also fell across the euro area, declining by an average 0.2% Good news then, one might think, so consumers may well be puzzled by the reaction of policy makers, with the ECB announcing its intention to take further action in order to raise prices and boost the euro inflation rate towards 2% per annum, citing the risk of deflation as the catalyst for the move. Why are falling prices deemed a bad thing when central banks have spent most of the last fifty years worrying about the problems caused by rising prices?
Not everyone is convinced that deflation currently exists in Europe because the concept involves the notion of a persistent fall in prices rather than a short term period of negative inflation. This in turn depends on what is causing prices to fall – is it in response to a supply shock such as a rise in oil production (which some economists have termed ‘good deflation’) or as a consequence of falling demand (‘bad deflation’.) Looking at the Irish CPI it is clear that a key factor is the sharp decline in global commodity prices , which started in earnest over the summer months and has resulted in declining food prices ( down 2.7% in the year to December) and energy costs ( down 5.5%). The latter has further to fall and largely for that reason most forecasts envisage the annual inflation rate staying negative in Ireland and across the euro area for at least the first half of 2015.
If one excludes energy and unprocessed food Irish prices rose, albeit by a modest 0.5%, and this points to the case against the prospect of deflation – energy prices will not fall for ever and so the deflationary impact on the CPI will eventually fade. Goods prices account for less than half of the Irish CPI (45%) and the price of services is still rising ( up 1.7% or 2.8% excluding mortgages) so a sustained fall in the CPI would probably in turn require a prolonged and heavy fall in wages. Ireland has seen a modest fall in wages on one measure (the micro data at industry level) but not on another (the aggregate wage figure used in the national accounts) while wage growth is positive on average across the euro area.
The performance of euro equity markets would also suggest that deflation is not a base case, and the ECB concurs, although stressing that the risks have risen. Modern experience of deflation is limited to Japan but prices also fell steadily during the Great Depression in the US and elsewhere, which has contributed to the association of falling prices with very negative developments in the real economy. The argument partly focuses on expectations , with households and firms postponing consumption and investment in anticipation of lower prices next year. Deflation will also affect real interest rates as nominal rates for most borrowers are bounded at or close to zero, implying real rates will rise if the price level falls. This would increase savings and reduce consumption and investment.Similarly, if nominal prices and incomes fall the real burden of household and government debt rises, a particular concern given the current scale of outstanding debt.
The expectations element in deflation has made central banks, including the ECB, very keen to monitor the private sector’s view on future prices. That can be hard to gauge (surveys tend to be strongly influenced by the recent trend) which makes market-based measures ( inflation swaps or derived from nominal versus real bond yields) popular as they can be monitored in real time. On that basis the US market is expecting inflation to average around 1.5% a year for rhe next decade while the ECB’s favourite measure suggests euro investors expect inflation in 5-years time to also average around 1.5% over the following 5 years.
Evidence, then, that inflation is expected to be low and certainly below the 2% level many central banks view as optimal, but not that there is a widespread belief that inflation will stay negative for a long time. This low inflation outlook is not a scenario which implies strong growth in nominal wages but certainly one in which short periods of falling prices is a positive rather than a negative.