Economic Outlook: Bubbles can still blow up with zero inflation
For many people, this is uncharted territory. Though retail price inflation fell to zero in February 2009, and was negative for the following eight months, this reflected the sharp reductions in interest rates at the time. Inflation as measured by the consumer prices index (CPI) remained positive throughout.
You have to go back 55 years, I suspect before many readers were born, for anything like this. The Office for National Statistics (ONS) has modelled the current CPI back to January 1950. It shows inflation last fell to zero in December 1959 and was negative by 0.5%-0.6% for three months.
Zero inflation is good news for the economy. Retail sales volumes rose 0.7% last month and were a booming 5.7% up on a year earlier. As far as retailing is concerned, deflation is not merely on the way — it has been with us for some time.
So the ONS’s average store prices fell by 3.6% in the 12 months to February, a record. Stores include petrol stations, so much of this reflected the drop in fuel prices over the past year. But prices were also modestly lower for both food and non-food stores. Falling prices genuinely are putting money into people’s pockets.
At this point it is customary to warn that, while a temporary bout of deflation is a good thing, you would not want to make a habit of it. Indeed. There are, however, a couple of other aspects to this. History rarely repeats itself, but if we look at what happened when inflation last fell to zero and turned negative, it did not usher in prolonged deflation.
By the end of 1960, inflation was heading back up towards 2%. By the end of 1961 it was 4% and by the middle of 1962 it was 5.6%. The 1960s were not a particularly high inflation period, but even with a very low start, prices rose by an average of 3.4% a year over the decade.
Not only that, but it is easy to forget how recent this experience of ultra-low inflation is in Britain. After four years above the 2% official target, inflation dropped below it only at the beginning of last year. As recently as September 2011, Britain had an inflation rate of 5.2%, and as recently as late 2013, the country’s “natural” or normal inflation rate seemed to be 3% rather than 2%. It is too early to say anything fundamental has changed.
The bigger danger is that this brush with deflation will take central bankers’ eyes off the ball. Before the crisis, the criticism was that the obsession with inflation targets allowed a toxic build-up of risk in the financial system and a huge rise in asset prices, particularly house prices.
There is a powerful echo of that today. At exactly the same moment the ONS released the latest inflation numbers a few days ago, it also published figures showing house prices up by 8.4% on a year earlier. Though this is slightly off the pace of last year, the juxtaposition neatly encapsulated the question I get asked most often: how can inflation be so low when house prices are rising so fast? Housing, after all, is a significant component of most people’s expenditure.
Inflation measures do not deal particularly well with housing costs. Those that do incorporate housing — the ONS’s CPIH measure, and the old retail prices index — while not showing zero inflation — have it very low: 0.3% and 1% respectively.
Nor is housing the only asset price that has been rising strongly. The stock market had a touch of the wobbles last week but is well up on its levels of a year ago. Government bonds (gilts) show a 12-month rise of more than 15%. The Bank of England would say some of this is deliberate. Keeping long-term interest rates low has been an aim of policy, and the counterpart to that is rising gilt prices.
The housing market has been part of the recovery story, and a deliberate policy target, and a by-product of that is higher prices. Whether or not there is a government bond bubble remains to be seen but there is not yet an obvious housing bubble. House prices in those parts of London where there was the greatest chance of it have been gently deflating.
The risk is that leaving interest rates too low too long inflates new bubbles. Already the sharp drop in inflation has persuaded the two hawks on the Bank of England’s monetary policy committee (MPC), Martin Weale and Ian McCafferty, to drop for the moment their call for higher rates.
Mark Carney, the Bank governor, having tried to pull the markets back from the view that rates were never going to go up, has in recent speeches pushed them out again, citing the threat from “persistent external deflationary forces” and the pound’s rise against the euro. Andy Haldane, the Bank’s chief economist, reckons that “policy needs to stand ready to move off either foot” and the next move in rates is as likely to be down as up.
That worries me. Kristin Forbes, another MPC member, rightly pointed out in a London Evening Standard article that most domestically based measures of inflation are stable. Service sector inflation, which is above 2%, has actually edged up in the past two months.
To be fair, Carney, along with Ben Broadbent, a deputy governor, made clear on Friday that they wlll not over-react to the drop in inflation and that they expect the next move in rates to be up.
The one-off effects of the big fall in oil prices will drop out over the next six to nine months, though second-round effects could last a little longer. Even so, the right response for the Bank to either high or low oil prices is, to quote Rudyard Kipling, “to treat those two impostors just the same”.
That means preparing the ground for a gradual “normalisation” of interest rates over the next two to three years: in other words, slowly raising them, starting later this year or early next, and forgetting talk of further cuts. After all, nobody would forgive the Bank for squandering the gift of low inflation, and for repeating the experience of the early 1960s. And nobody would forgive it for allowing dangerous bubbles to inflate again. Inflation at zero is a happy accident. It should not be allowed to develop into a nasty accident.
PS: An economic urban myth, aired in both the Financial Times and The Economist, is in danger of becoming accepted fact. This is that French workers produce as much in four days as British workers in five. They could, in other words, take Friday off and still generate as much per week as British workers.
It is time to kill it. It is true, and has been for at least 25 years, that French labour productivity is higher than British. French workers benefit from higher capital — more investment — in part because of France’s onerous labour laws. Firms prefer to invest rather than employ. So France has weak employment growth and higher unemployment, a 10.2% rate (and 24.9% youth unemployment) against 5.7% and 16.2% in Britain.
It is also true that for every hour French workers work, they produce 26% more than British workers, which is where the myth arises. But, importantly, British workers work more hours a week than French workers, whose average is just 28.6 hours. So the relevant measure is output per worker, which shows that French workers produce 13% more in a week than Britons, but the productivity gap has been narrowing in recent years.
If they worked more hours, maybe French workers would produce more in four days than Britons in five, but they don’t. As it is, they can knock off a bit earlier on Fridays. But they probably do that anyway.
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