Inflation is declining across most of the industrialised world. The inflation rate is well below the target rate of 2.0% set for it by central banks in the US, euro area and UK. The downward pressure on prices in Europe is especially marked. Inflation rates have dropped below 1.0% in most European countries and, for the euro area as a whole, prices fell by 0.2% in the year to December. In the UK prices rose by just 0.5% over the same period, the lowest reading in 25 years.
In the coming months, as lower oil and other commodity prices feed through to consumers, inflation pressures are likely to moderate and, in Europe, deflation, or outright declines in prices, will become more prevalent.
Receding inflationary pressures have prompted concerns about the danger of a sustained period of deflation, especially in Europe. The spectre that haunts policymakers is of Japanese deflation in the 1990s and 2000s. Over this period prolonged bouts of deflation alternated with spikes in inflation. But between 2000 and 2013 Japanese consumer prices fell by 5.0%; over the same period prices rose 40% in the US and 33% in the euro area. Asset prices fell far faster than consumer prices, with Japanese land prices halving in value.
Deflation has a self-reinforcing, depressant effect on activity. Falling prices encourage consumers and businesses to defer expenditure on the grounds that the goods will be cheaper in the future. Deflation spills over into housing and equity prices, depressing household wealth and confidence. With levels of debt fixed, and asset prices and incomes shrinking, debtors are forced to cut spending in order to pay down their debts. Japanese firms, facing weak sales and unable to raise prices, cut wages, which further weakened demand.
We think that the risk of deflation becoming entrenched in the US and UK are low. Both economies are seeing good growth. Monetary policy is increasingly stimulative as declining interest rate expectations drive down borrowing costs for consumers and companies.
Inflation in the US and UK has been depressed by lower food, energy and petrol prices. Low inflation, or even a period of deflation, should boost consumer spending power, just as high prices in recent years have depressed activity. Deloitte's Consumer Tracker, which will be released later this month, shows that in the UK lower prices for essentials, such as petrol and food, is freeing consumers to spend more on discretionary purchases including going out, restaurants and big ticket items. Falling unemployment in the US and UK seem also seem likely to push wages up this year, even as inflation recedes. For the US and UK low inflation should provide a timely boost to the consumer and to growth.
Persistent deflation is a greater risk in the euro area, though one that we think is likely to be avoided. Euro area inflation has been dragged lower by cheaper energy and food costs, a process reinforced by deflation in the crisis-afflicted periphery. Ireland and the Mediterranean countries lost competitiveness during the good years, and wages and prices rose excessively. In a monetary union, nations cede the power to set interest rates, devalue or print money. To restore competitiveness, wages and prices need to fall. Since the financial crisis labour costs in Greece have fallen by a remarkable 27%, in Ireland by 17% and in Spain by 9%. Reduced wages have fed through to falling prices in all these countries. In a monetary union deflation is the inevitable and logical way for a country to counter a loss of competitiveness.
Stripping out energy and food prices, and the effect of peripheral deflation, and the euro deflation seems less dramatic. In Germany core inflation, excluding food and energy, is running around the 1.7% mark, close to its average for the last 10 years.
Nonetheless, policy makers take the risk of sustained euro area deflation seriously. Central Banks around the world have spent years studying Japan's experience and they know that, once established, deflation is hard to reverse. Saturday's Financial Times reported that the European Central Bank is likely to react to the region's fall into deflation by launching a programme of Quantitative Easing (QE), or purchases of government bonds, to bolster growth and counter deflation, this Thursday.
We think QE and lower prices will help keep growth going in the euro area this year. Deflation is should prove temporary. If lower prices feed back into lower wages the odds of deflation becoming embedded rise. We will be watching wage data in the US, the euro area and the UK closely for to gauge the risk of sustained deflation.
On the final day of his trip to the US last week UK Prime Minister David Cameron said that he hoped that companies would pass on the benefits of lower fuel prices as wage increases. With official data showing that outside the financial and oil sectors UK corporate profitability is at the highest level since 1998 we think that, in the UK at least, the stage is set for wages to rise this year as inflation recedes.
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