Bootle on Deflation

Roger Bootle’s quarterly Deloitte Economic Review rarely disappoints and the new edition which is available here provides a timely and crystal-clear explanation of the demand and supply-side factors that might bring about price deflation in the UK economy during 2009 and into 2010.

Seven forces are raised as contributing to downward pressure on the general price level

1. The sharp fall in global food and energy prices
2. Intense competition amongst retailers such as deep-discounting to maintain cash flow and market share
3. The impact of the temporary cut in VAT from 17.5% to 15%
4. Falling housing costs including lower mortgage interest repayments (which affects RPI inflation)
5. The lagged effects of a large margin of spare capacity in the economy due to the negative output gap
6. Downward pressure on basic pay settlements and average earnings - how many people will take pay cuts this year?
7. The sustained and persistent decline in asset prices with consequences for consumer confidence and aggregate demand

For AS students - consider how these forces might be explained and illustrated using AD and SRAS analysis.

The risks of price deflation are not insignificant, indeed as Bootle points out, price deflation might have been rare during the latter part of the twentieth century but we have had plenty of instances of it in the UK in earlier ages.

What of the likely consequences of a bout of price deflation?

Some of the forces mentioned above are indeed likely to be temporary (the VAT cut is reversed in 2010) and some will have favourable effects on real income and spending power. But the consensus seems to be that deflation can have a pervasive and damaging effect on the real economy:

1. A rise in the real value of debts - personal, corporate and state
2. A change in the psychology and expectations of businesses and consumers
3. Second round effects including pressure for wages to fall and output to be cut back further
4. The possibility that the usual instruments of monetary policy become ineffective
5. Consequences for welfare benefits - will the government cut unemployment and state pensions in a world of deflation?
6. The damaging effects on the corporate sector of falling prices and profit margins

Sterling’s continued depreciation perhaps holds out the best hope of avoiding deflation this year as does a partial rebound in the price of oil and gas and other inputs. Bootle predicts that - having cut policy interest rates to the bare bones of 1.5% - the Government and Bank of England are likely to resort to further emergency measures to prevent a Japanese-style deflationary spiral.