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Video recorded in April 2010 but the issues remained very relevant in 2013 (despite some warnings of inflation heading into 2014)

Hong Kong Composite Consumer Price Index - Source: HK government

Future of Banking: At the 2003 World Economic Forum meetings in Davos there was much talk about the possibilities of deflation: a real and growing threat to a number of economies, despite the fact that most governments have been obsessed with reducing inflation. Indeed entire government economic policy has often been focussed on just one main factor: killing inflation. Why?

Soaring inflation rates have been blamed for many national crises and even for causing wars. Time and again we have seen countries with out-of-control cost of living rises: strikes, industrial action and high wage demands all feeding into higher production costs, encouraging a spiral of further upward pressures on consumer prices. Inflation is often blamed for destroying the value of savings, and making people poor. But collapsing prices also creates a crisis - as we see in cycles of boom, bustle and bust.

Need a world-class keynote speaker on the global economy or banking? Phone Patrick Dixon now or email.

The US was deflating in 40% of goods and services

But the reality in 2002 was deflation across many industry sectors. Take the US economy. Prices for 40 percent of all the goods and services in the Labor Department's consumer price index (CPI) showed year-over-year declines in September 2002, according to research by Merrill Lynch's chief Canadian economist David Rosenberg. Corporations in the deflating sectors below form 25% of the stocks in Standard and Poor's 500 index.

Some think governments are being too slow to recognise the great dangers of low inflation, where a single economic blow can push an entire nation over the edge into deflation, with falling cash values of every asset and every investment.

Deflation means a complete mental rethink and is beyond the understanding of most people today who were raised in inflationary times. The real question is an emotional one: how will ordinary people behave if they think prices are going to fall year on year for more than a very short period?

And how will investors in the market behave? As we saw in Japan (1990s), if they start pricing in an expectation of deflation across most sectors, rather than just 40% in some sectors, it will have a significant effect on valuations and reduce appetite even more for buying stocks.

Consumers often rely on inflation to help them repay debts - particularly house loans. Inflation of 5% means a mortgage is only half what it was in real terms in 15 years.

What happens in deflation?

When prices fall, the value of cash rises. Anyone with money has an advantage and those with debts lose. If I have a mortgage of $250,000 this year, and deflation runs at 5% a year, it means in real terms my loan will double in size over 15 years. Most worryingly, in deflation, my loan (which was only 70% of the value of my home) will become so huge that even if I sell my home, I will be left with large debts.

We have all seen deflation before in one key area: computers and digital technology where deflation has been eating away at price levels for three decades or more. But this is different. It is one thing to write off an investment in a computer system over three years, but another to find that one of your greatest assets, your own home, is worth only a small fraction of what it was twenty years ago, and that prices of every other asset you own are also expected to go on falling.

Of course if you have cash in hand, the temptation is to spend nothing, and invest in nothing. What is the point of buying when you know that in six months time the chances are you could buy more? So money gets left as cash under the bed, or in a bank account (if you are prepared to risk the bank going bust because so many loans were secured against assets, now worth almost nothing). Spending falls, feeding a further frenzy of price cutting, downward pressure on salaries, bonus cutting, and so on. But it is easier to pay people less and get away with it when they know they need less to live on this year than last year.

Interest rates fall to zero, because no one in their right minds wants to borrow large amounts of an asset (cash) which is going to inflate with time. Indeed the only asset for ordinary men and women that grows in value in a deflationary economy is cash, and cash is what you find they hang on to. Just look at Japan which has experienced deflation for years with terrible consequences.

How serious is the risk of deflation hitting other economies?

What happens when interest rates fall to zero

The main tool that governments use to control inflation is interest rates, but this tool can lose its power if rates are already so low that there is hardly any room left to cut further before the cost of borrowing falls to zero. Another terrorist shock, a war in Iraq that goes badly wrong, or some other national calamity... it is not hard to imagine a scenario where further rate cuts become necessary.

Think about it from the ordinary man or woman in the street's point of view. If interest rates are zero, I can go out and get a huge loan and it costs me nothing at all. Of course the loan must one day be repaid, but when? The bank soon realises I am over extended and cannot repay, but is in no hurry because the loan repayments will be worth more to them in the future, if they give me longer to find the money. They are not losing a penny in interest because the interest rate is zero. In fact every day the bank waits, the more they make, because the price of money is rising as the price of everything else falls - that is the reality of deflation.

Old economics relied on inflation running at a safe modest level - not too high and not too low. It taught us that raising the cost of borrowing also raises the returns to savers, and sucks money out of the economy so less is around to be spent by consumers, goods hang around before being sold and market prices are constrained. Lowering interest rates encourages people to spend without worrying, more cash chases goods for sale, prices rise.

Unfortunately there are a number of drivers of deflation, so it will be easy for governments to find rates lower turn out lower than they expected. That's why banks try to keep a margin for error and will take radical steps to prevent inflation falling from - say - an absolute minimum of 2.5% or even 3% a year.

Deflation Drivers

1. Globalization: every time a job moves from a high income country to a low income country, the price of production falls, and the potential for price cutting increases, while maintaining profits and market share. We are currently witnessing rapid and accelerating changes in industry and services. Even less developed countries like Mexico are finding large chunks of their manufacturing capacity moving to places such as China. India is taking a significant share of software development, with entire teams being made redundant in the UK and the US, replaced by teams twice the size at a fraction of the cost in places like Hyderabad and Bangalore. And as prices rise in places like coastal China, jobs will shift to other less developed regions.

2. Technology innovation: every time a new production process is developed, using less people and less resources, prices fall. In the past, technology purchases formed only a small part of our lives, but the techno-economy continues to grow dramatically, despite the hype and gloom of investors. And the indirect spin-offs are becoming greater every day. Take for example food technology and processing, where new automated packaging and distribution systems have contributed to falling food prices for over a decade, or new farming methods with increased yields, or the impact of online business to business relationships and just-in-time delivery systems.

3. Economic cycles and global shocks. Every economy goes through ups and downs and events outside any government's control also have impact. Take for example major terror attacks or turmoils in the Middle East affecting oil prices, which have recently fluctuated widely and may continue to do so. When oil prices rise, there is inflationary pressure. Governments respond by factoring this into decisions to raise interest rates and inflation falls towards a base level. But if that minimum is too low, what happens if there is another major downwards correction and for a while oil prices fall very significantly? The answer is an added risk of undershooting and causing deflation.

Acting to prevent further deflation

So then, as we have seen, sectors in many economies are already deflating. What can governments do of they are worried about deflation, or to correct national deflation once it starts?

Firstly they can cut interest rates more aggressively while they are still able.

Secondly they can suspend or revoke tax rises for a limited period. Thirdly they can increase expenditure. Both these options of course affect government debt and are sustainable only in the short term without profound consequencies.

In summary then, both inflation and deflation pressures can worry governments, with potential risks to stability in countries where inflation has been allowed to fall too low. Governments should be expected to act from time to time, aiming to maintain around 2.5% to 3.0% inflation throughout economic cycles, giving room for adjustments and economic shocks in both directions.

Need a world-class keynote speaker on the global economy or banking? Phone Patrick Dixon now or email.

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