Deflation is currently a concern in the UK and across Europe. However, relative to Japan, the deflation concern is small. In Japan, deflation has been problematic for more than two decades and this has had significant implications for the Japanese economy.
‘Abenomics’ has been in practice in Japan, as the Prime Minister, Shinzo Abe, has been trying to reflate the economy. Growth has been improving and the deflation concern appeared to be under control. However, GDP data now shows that the economy is once again declining and so with aggregate demand falling, this pushes down average prices across the economy and so the deflation risk re-emerges. This article from BBC News and another from The Guardian look at the economic policy known as ‘Abenomics’ and how the Japanese economy is faring.
Articles
Off target: Is it the end of ‘Abenomics’ in Japan? BBC News, Rupert Wingfield-Hayes (15/2/16)
Japan’s economy shrinks again as Abenomics is blown off course The Guardian, Justin McCurry (15/2/16)
Previous blogs
Japan’s deflation fears grow (update) (27/2/16)
Riding the Japanese roller coaster (15/2/16)
Japan’s interesting monetary stance as deflation fears grow (14/2/16)
Japan’s arrows missing their target (17/11/14)
Japan’s recovery (3/2/14)
Abenomics – one year on (16/12/13)
Japan’s three arrows (6/6/13)
Questions
- What are the key features of Japan’s ‘Abenomics’?
- Why is deflation such a concern? Surely falling prices are good for consumers and hence the economy.
- How has Japan been trying to reflate its economy and why has this failed?
- The yen is getting stronger, but how will this affect the Japanese economy? Use a demand and supply diagram to illustrate what has caused the value of the yen to fall and an aggregate demand and supply diagram to show the impact.
- Negative interest rates have been implemented in Japan. What does this mean for savers and borrowers and the economy?
- How do you think Japan’s stance on immigration and structural change is affecting its macroeconomy?
On August 11th, China devalued its currency, the yuan, by 1.9%. The next day it devalued it by a further 1.6% and on the next day by a further 1.1%. Even though the total devaluation was relatively small, especially given a much bigger revaluation over the previous three years (see chart below), traders in world markets greeted the news with considerable pessimism. Stock markets around the world fell. For example, the US Dow Jones was down by 1.1%, the FTSE 100 was down by 2.5% and the German DAX by 5.8%.
There are three major concerns of investors about the devaluation. The first is that a weaker yuan will make other countries’ exports more expensive in China, thereby making it harder to export to China. At the same time Chinese imports into the rest of the world will be cheaper, thereby making it harder for domestic producers to compete with Chinese imports.
The second is that cheaper Chinese imports will put downward pressure on prices at a time when inflation rates in the major economies are already below target rates. The fear of deflation has not gone away and this further deflationary twist will intensify such fears and possibly dampen demand.
The third is that the devaluation is taken as a sign that the Chinese authorities are worried about a slowing Chinese economy and are using the devaluation to boost Chinese exports. The rapidly expanding Chinese economy has been one of the major motors of the global economy in recent years and hence a slowing Chinese economy is cause for serious concern at a time when the global economy is still only very slowly recovering from the shock of the financial crisis of 2007–8
But just how worried should the rest of the world be about the falling yuan? And will it continue to fall, or could this be seen as a ‘one-off’ correction? What effect will it have on the macroeconomic policies of the USA, the eurozone and other major countries/regions? The following articles analyse Chinese policy towards its currency and the implications for the rest of the world.
China weakens yuan for a third straight day on Thursday CNBC, Nyshka Chandran (13/8/15)
Markets reel as investors fear worst of Chinese slowdown is yet to come The Telegraph, Peter Spence (12/8/15)
China cannot risk the global chaos of currency devaluation The Telegraph, Ambrose Evans-Pritchard (12/8/15)
Beware a China crisis that could crash down on us all The Telegraph, Liam Halligan (15/8/15)
The curious case of China’s currency The Economist, Buttonwood’s notebook (11/8/15)
China’s yuan currency falls for a second day BBC News (12/8/15)
China slowdown forces devaluation BBC News, Robert Peston (11/8/15)
What the yuan devaluation means around the world BBC News, Lerato Mbele, Daniel Gallas and Yogita Limaye (12/8/15)
China allows yuan currency to drop for third day BBC News, various reporters (13/8/15)
The Guardian view on global currencies: it’s the economy, stupid The Guardian, Editorial (14/8/15)
China’s currency gambit and Labour’s debate about quantitative easing: old and new ways to cope with economic crisis The Guardian, Paul Mason (16/8/15)
Questions
- By what percentages have the nominal and real yuan exchange rate indices appreciated since the beginning of 2011? Use data from the Bank for International Settlements.
- Explain the difference between nominal and real exchange rate indices.
- Compare the changes in the yuan exchange rate indices with that of the yuan/dollar exchange rate (see Bank of England Interactive Database). Explain the difference.
- How is the yuan exchange rate with other currencies determined?
- How have the Chinese authorities engineered a devaluation of the yuan? To what extent could it be described as a ‘depreciation’ rather than a ‘devaluation’?
- Why have world stock markets reacted so negatively to the devaluation?
- Why, in global terms, is the devaluation described as deflationary?
- How much should the rest of the world be worried by the devaluation of the yuan?
- Explain the statement by Robert Peston that ‘Beijing has done the monetary tightening that arguably the US economy needs’.
- Comment on the following statement by Stephen King of HSBC (see the second Telegraph article below): ‘The world economy is sailing across the ocean without any lifeboats to use in case of emergency.’
The CPI index fell by 0.1% in the 12 months to April 2015. This is partly the result of lower air and sea fares, as the upward ‘blip’ in these fares at Easter last year was not present in mid-April this year as Easter fell outside the period when the statistics are collected. What is more significant is that fuel, commodity and retail food prices have fallen over the past 12 months, and the exchange rate has risen, especially against the euro.
But how do we define what’s happened and how significant is it? It might seem highly significant as it’s the first time in 55 years that the CPI has fallen over a 12-month period. In fact, the effect is likely to be temporary, as fuel prices are now rising again and commodity prices generally are beginning to rise too. What is more, the pound seems to have peaked against the euro. Thus although aggregate demand remains relatively dampened, the main causes of falling prices and potential rises in the coming months are largely to be found on the cost side. This then brings us on to the definition of a falling CPI.
A falling CPI over a 12-month period can be defined as negative inflation. This is unambiguous. But is this ‘deflation’? The problem with the term ‘deflation’ is that it is ambiguous. On the one hand it can be defined simply as negative inflation. In that case, by definition, the UK has experienced deflation. But on the other, it is used to describe a situation of persistent falling prices as a result of declining aggregate demand.
If an economy suffers from deflation in this second sense, the problem can be very serious. Persistent falling prices are likely to discourage consumers from spending on durables (such as fridges, TVs, cars and furniture) and firms from buying capital equipment. After all, why buy an item now if, by waiting, you can get it cheaper later on? This mentality of waiting to spend leads to falling aggregate demand and hence falling output. It also leads to even lower prices. In other words deflation can get worse: a deflationary spiral.
If we define deflation in this second, much more serious sense, then the UK is not suffering deflation – merely temporary negative inflation. In fact, with prices now falling (slightly) and wages rising at around 2% per year, there should be an increase in aggregate demand, which will help to drive the recovery.
Videos
Should Britain Panic Over Negative Inflation? Sky News, Ed Conway (20/5/15)
UK inflation negative for first time since 1960; BoE says temporary Reuters, Andy Bruce and William Schomberg (19/5/15)
UK inflation negative for the first time since 1960 CNBC, Dhara Ranasinghe (19/5/15)
Articles
UK inflation rate turns negative BBC News (19/5/15)
Why there’s little to fear as the spectre of deflation descends on UK The Telegraph, Szu Ping Chan (19/5/15)
UK inflation turns negative The Guardian, Katie Allen (19/5/15)
Is the UK in the early stages of deflation? The Guardian, Larry Elliott (19/5/15)
Is the UK in deflation or negative inflation? Q&A The Guardian, Katie Allen and Patrick Collinson (19/5/15)
Market View: Economists unconcerned on temporary deflation FT Adviser, Peter Walker (19/5/15)
Questions
- Is negative inflation ever a ‘bad thing’?
- Explain the movement in UK inflation rates over the past five years.
- How do changes in exchange rates impact on (a) inflation; (b) aggregate demand? Does it depend on what caused the changes in exchange rates in the first place?
- Why is the current period of negative inflation likely to be short-lived?
- Would you describe the negative inflation as negative cost-push inflation?
- What factors could change that might make negative inflation more persistent and raise the spectre of deflation (in its bad sense)?
- If inflation remains persistently below 2%, what can the Bank of England do, given current interest rates, to bring inflation back to the 2% target?
- What is meant by ‘core inflation’ and what has been happening to it in recent months?
- What global factors are likely to have (a) an upward; (b) a downward effect on UK inflation?
The latest inflation figures, as detailed in February’s Consumer Price Inflation Statistical Bulletin, show that the annual rate of CPI inflation hit zero in February. This is down from 0.3 per cent in January. While inflation is now well outside the 1-3 per cent target range that the Bank of England is charged with meeting, perhaps a more pertinent question is whether the UK is teetering on the brink of deflation – and the risks that may carry.
To get a better sense of the latest inflation picture we need to delve deeper into the numbers and look at the patterns in the prices that make up the overall Consumer Price Index. Interestingly, these shows that five of the 12 principal product groups that make up the index are currently experiencing price deflation.
As explained in Consumer Price Inflation: The 2015 Basket of Goods and Services, produced by the ONS, around 180,000 prices quotations are collected each month for around 700 representative items. These goods and services fall into one of 12 broad product groups. These include, for example, food and non-alcoholic beverages and transport.
The items included in each of the 12 product groups are reviewed once a year so that the chosen items remain representative of today’s spending patterns. A monthly price index is calculated for these 12 broad groupings, known as divisions, and for sub-categories of these. For example meat is a category within food and non-alcoholic beverages. The overall CPI is a weighted average of the 12 broad groupings.
The annual rate of CPI inflation in February 2015 was zero. This means that the price of the representative basket of goods and services was unchanged from its level in February 2014. As Chart 1 shows (click here for a PowerPoint of the chart), the annual rate of CPI inflation series goes back to January 1989 and this is the first time it has fallen to zero. Its average over this period is in fact 2.7 per cent. The recent fall is quite stark with the rate of CPI inflation in June 2013 close to the top-end of the Bank of England’s target range at 2.9 per cent.
Of the 12 product groups, five constitute 10 per cent or more of the overall weight of the CPI index. These weights are dependent on the relative level of expenditure comprised by each division.
Chart 2 shows the annual rates of inflation for these five groups (click here for a PowerPoint of the chart). The most heavily-weighted component is transport (14.9%), which includes the price of fuel and passenger transport. Here we observe deflation with prices 2.7 per cent lower year-on-year in February. This is the fourth consecutive month where its annual rate of price inflation has been negative.
The second most heavily-weighted component within the CPI index is recreation and culture (14.7%), which includes games, toys and audio-visual equipment. Here too we see the emergence of deflation. In February 2015 prices were 0.8 per cent lower than in February 2014. Deflation is most prevalent in the fifth most heavily-weighted component (11.0%): food and non-alcoholic drinks. The price for this division of the CPI was 3.3 per cent lower in February 2015 as compared with February 2014. In nine of the last ten months the price of food and non-alcoholic drinks, helped by aggressive price competition in the grocery sector, has been lower year-on-year.
February also saw a negative annual rate of inflation emerge for the first time in the CPI division capturing furniture and household equipment and appliances (-0.3 per cent). Further, miscellaneous services, which include personal care and personal effects (e.g. jewellery) saw an annual rate of deflation for the eight consecutive month. The annual rate of inflation for miscellaneous services stood at -0.4 per cent in February. However, February did see an upturn in price inflation for clothing and footwear with prices 1.7 per cent higher than a year earlier while the price of alcohol and tobacco was 3.8 per cent higher year-on-year.
The detailed inflation numbers do reveal the extent to which many CPI divisions are already characterised by deflation. It is interesting to note that in A Comparison of Independent Forecasts published monthly by HM Treasury, the forecast for the final quarter of 2015 is for the annual rate of CPI inflation to be running at 0.8 per cent. An important reason for this is that the effect of falling fuel prices from November 2014 will begin to drop out of the year-on-year inflation rate calculations. The removal of this effect should help to prevent the specter of deflation provided that peoples’ inflationary expectations remain anchored, i.e. exhibit stickiness. If these were to be revised down, however, this would further contribute to downward pressure on prices since input price inflation – including wage inflation – would again be expected to fall.
Articles
U.K. on Brink of Falling Prices as Inflation Rate Drops to Zero Bloomberg, Tom Beardsworth (24/3/15)
UK inflation rate falls to zero in February BBC News (24/3/15)
Britain sees no inflation in February for first time on record Reuters, David Milliken and Andy Bruce (24/3/15)
Inflation hits a record zero boosting household incomes Independent, Clare Hutchinson (24/3/15)
Inflation Hits 0% As Food Costs Fall Further Sky News (24/3/15)
Inflation falls to zero in February as Britain heads to deflation Telegraph, Szu Ping Chan (24/3/15)
UK inflation hits zero for the first time on record Guardian, Angela Monaghan (24/3/15)
Data
Consumer Price Inflation, February 2015 Office for National Statistics
Consumer Price Indices, Time Series Data Office for National Statistics
Questions
- Explain the difference between a decrease in the level of prices and a decrease in the rate of price inflation. Can the rate of price inflation rise even if price levels are falling? Explain your answer
- Explain what is meant by deflation.
- In what ways might deflation affect the behaviour of people? What effect could this have on the macroeconomy?
- Why do you think policy-makers, such as the Monetary Policy Committee, would be interested in the inflation rates within the overall CPI inflation rate?
- What factors do you think lie behind the fall in the transport component of the CPI?
- Explain why the rate of inflation would be expected to rise in the late autumn, a year on from when the transport component of the CPI began falling.
- Does the possibility of deflation mean that inflation rate targeting has failed?
The first link below is to an excellent article by Noriel Roubini, Professor of Economics at New York University’s Stern School of Business. Roubini was one of the few economists to predict the 2008 financial crisis and subsequent recession. In this article he looks at the current problem of substantial deficiency of demand: in other words, where actual output is well below potential output (a negative output gap). It is no wonder, he argues, that in these circumstances central banks around the world are using unconventional monetary policies, such as virtually zero interest rates and quantitative easing (QE).
He analyses the causes of deficiency of demand, citing banks having to repair their balance sheets, governments seeking to reduce their deficits, attempts by firms to cut costs, effects of previous investment in commodity production and rising inequality.
The second link is to an article about the prediction by the eminent fund manager, Crispin Odey, that central banks are running out of options and that the problem of over-supply will lead to a global slump and a stock market crash that will be ‘remembered in a hundred years’. Odey, like Roubini, successfully predicted the 2008 financial crisis. Today he argues that the looming ‘down cycle will cause a great deal of damage, precisely because it will happen despite the efforts of central banks to thwart it.’
I’m sorry to post this pessimistic blog and you can find other forecasters who argue that QE by the ECB will be just what is needed to stimulate economic growth in the eurozone and allow it to follow the USA and the UK into recovery. That’s the trouble with economic forecasting. Forecasts can vary enormously depending on assumptions about variables, such as future policy measures, consumer and business confidence, and political events that themselves are extremely hard to predict.
Will central banks continue to deploy QE if the global economy does falter? Will governments heed the advice of the IMF and others to ease up on deficit reduction and engage in a substantial programme of infrastructure investment? Who knows?
An Unconventional Truth Project Syndicate, Nouriel Roubini (1/2/15)
UK fund manager predicts stock market plunge during next recession The Guardian, Julia Kollewe (30/1/15)
Questions
- Explain each of the types of unconventional monetary policy identified by Roubini.
- How has a policy of deleveraging by banks affected the impact of quantitative easing on aggregate demand?
- Assume you predict that global economic growth will increase over the next two years. What reasons might you give for your prediction?
- Why have most commodity prices fallen in recent months? (In the second half of 2014, the IMF all-commodity price index fell by 28%.)
- What is likely to be the impact of falling commodity prices on global demand?
- Some neo-liberal economists had predicted that central bank policies ‘would lead to hyperinflation, the US dollar’s collapse, sky-high gold prices, and the eventual demise of fiat currencies at the hands of digital krypto-currency counterparts’. Why, according to Roubini, did the ‘root of their error lie in their confusion of cause and effect’?
Deflation is currently a concern in the UK and across Europe. However, relative to Japan, the deflation concern is small. In Japan, deflation has been problematic for more than two decades and this has had significant implications for the Japanese economy.
