Don’t be too afraid of the big bad wolf of deflation

Last week we heard that inflation as measured by the Consumer Price Index fell from 1% in November to 0.5% in December, reaching its lowest rate since May 2000. However, Economist David Smith, writing in December, forewarned us of this likelihood and offered suggestions as to why we should not panic about falling prices and why it would be unwise to start ‘screaming’ about a deflationary period in the near future.

Here are Smith’s three reasons why we should stay calm about low inflation rates.

First, while it is possible if oil prices were to collapse to, say, $40 a barrel, inflation could go negative, it is unlikely to stay negative. Even in the highly uncertain conditions of 2009, a sharp fall in oil and commodity prices passed through only into temporarily low inflation. Inflation rose, even alongside the initially weak recovery.

What economists call ‘base effects’ – the simple fact that you can benefit from a one-off price shock only once – are likely to push inflation higher as we move into the latter part of 2015.

Second, it is very clear where the downward pressure on prices is coming from. Food and non-alcoholic drinks prices were 1.7% lower last month than a year earlier, reflecting lower commodity prices and supermarket competition. Fuels and lubricants for cars were 5.9% lower as a result of the drop in world oil prices, with more to come.

There has also been a drop in so-called core inflation, excluding food, energy and alcohol. But, even more than the consumer prices index, it is unlikely to go negative for any sustained period of time.

A better measure of domestically generated inflation is service-sector inflation. Last month this was running at 2.4%. In June it was 2.5%. This does not point to an economy sliding into sustained deflation.

Third, differentiate between the idea of good and bad deflation. Bad deflation is that which results from chronically weak demand. Nobody could pin that on Britain. In November, helped by Black Friday madness, we bought 6.4% more goods than a year earlier.

Good deflation, by contrast, is when prices fall because of a beneficial price shock. The plunge in oil prices and the weakness of the commodity prices are delivering a gift to the economy that we should seize with both hands.

Good deflation is good news!

For more information please see the original article: The Sunday Times, 21st December 2014, Business Section, ‘Don’t be too afraid of the big bad wolf of deflation’, David Smith. P.4.

Further references include BBC News. Please use the following link:

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