Tuesday, February 17, 2009

Stoking Up Inflation

Quick nurse! He's fading. Give him another shot!

As regular readers will know, we think the current desperate attempts to stop the pain at any price will result in a return to 70s style inflation.

Back in the era of platform boots, we learned the hard way that high inflation can easily exist alongside a slumping economy. All you need is an overdose of monetary and fiscal stimulants.

And with our fiscal deficit heading for a record shattering 12% of GDP, monetary growth bounding along at 16% pa, and sterling already 25% lower, an overdose is precisely what we're being given.

But of course that's not what we're currently being told. Right now, informed opinion at the bedside - from the government, to the Bank of England, to the Times leader - is that we must keep on pumping the stimulants lest we fall into the coma of deflation. Here's how the Times puts it:
"... a long period of general price falls, as happened in Japan in the 1990s, would be damaging. Consumers would postpone purchases, as they would be able to buy goods more cheaply in a year or two. Employment and investment would collapse. Stock prices would fall as corporate earnings would contract. Most damaging, households with debt - either mortgage debt or unsecured loans - would suffer intense hardship. Adjusted for inflation, the value of their debt burden would rise. Deflation would cause hardship, eviction and widespread corporate and personal bankruptcy."

The basic idea is that unless we stoke up some inflation pronto, we're heading into the abyss.

There are a couple of key points to make.

First, as we've blogged many times (eg here), debtors are not the only people governments should be concerned about. Savers - who BTW outnumber borrowers - have already been whacked by collapsing interest rates, and are placed at considerable further risk by policies which effectively discount the chances of future high inflation. Why should they be punished to bail-out the profligate?

Second, although the idea of "general price falls" is widely touted, and at first glance seems to be indicated by the charts like the one shown above, in reality we are still some way from that.

According to today's inflation stats from the ONS, inflation on the traditional RPI measure has now plunged to roughly zero (just 0.1% year-on-year). And when you break down the 12 month change, you find the RPI price level has actually fallen every month since September - 3.8% total decline. So the dreaded deflation is here already! Gulp!

But when you look beneath the headline RPI figure (even setting aside the fact that the RPI measure was long-since replaced by the CPI measure as the target for monetary policy), you find that the key drivers of its recent fall have been - yes, you guessed it - the cut in mortgage rates, and the cut in petrol prices.

Here's the ONS chart showing how that 0.1% year-on-year increase breaks down:

As we can see, price deflation is actually confined to just four areas: housing, motoring expenses, clothing and footware, and leisure goods. All the other areas of spending, which together comprise over half the RPI basket, continued to see price rises - some of them quite chunky (eg food).

Now let's just think about those four areas that have seen price falls: will "consumers postpone purchases, as they would be able to buy goods more cheaply in a year or two"?

Housing, motoring, clothing and footware, and leisure goods. Hmm... what do you reckon?

Take clothes and footware (4.2% of the RPI basket). I guess it's just about possible that Mrs T will hold off adding to her Imelda Marcos shoe mountain in the hope of buying cheaper in 2011. But I have to say I'm not confident about that. Because in reality, clothing and footware prices have been falling for years (down 20% since 2005), and it hasn't stopped her so far.

And motoring? Yes, we can see car sales have collapsed, so maybe people are holding off for a bargain. But then again, when you look at the detail, you find that new car prices aren't really falling - the big falls are in secondhand cars (down 15.4% yoy). Indeed, with sterling flat on its back, Ford and General Motors recently announced 5% price rises. And anyway, the bulk of motoring's 13.3% in the RPI basket comprises much less discretionary things, like fuel and insurance, rather than car purchase.

Housing? Yes, well, we're certainly telling the junior Tylers there's no rush to buy because prices are still falling, so there's certainly a point there. But surely only a madman would deliberately stoke up inflation in an attempt to re-establish the insane unsustainable prices we've seen in recent years.

As for those leisure goods, they mainly comprise consumer electronics. And since they're all imported, postponing purchase will barely register in terms of UK GDP - indeed, to the extent that people spend on domestically produced goods instead, it could be a positive bonus.

The bottom line is that we are nowhere near the scary deflation scenario being promoted by current groupthink.

We remain much more concerned about the risks of a return to 70s-style inflation. Not this year, for sure. Maybe not even next year. But by 2011, we'll be watching central banks racing round as they try to slam shut yet another set of stable doors.

Unfortunately, by then the horse will be well over the hill, and will be rampaging along a High Street near you.

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