Disinflation and Deflation

To judge from the instantaneous reactions of the news channels the British economy is on the edge of a deflationary precipice. Journalists anxious to put a fresh spin on their well-worn recession / credit crunch story-lines are now turning their attention to headline grabbing reductions in food and petrol prices and extrapolating that – pretty soon – the economy will be in the grips of a deflationary recession.

Hold on a minute.

Today’s inflation numbers are certainly worthy of note.

The annual rate of CPI inflation dipped from 5.2% in September to 4.5% in October. RPI inflation (another measure of the rate of change of the cost of living) also fell from 5% in September to 4.2% last month. This is disinflation – but it is not deflation which we define as a persistent and sustained reduction in the general level of prices.

The main driver of this reduction in the annual rate of inflation is the cost of transport. Steep reductions in world crude oil prices are now filtering through to the forecourts with a litre of diesel now 7 pence cheaper than a month ago and air transport fuel surcharges gradually being withdrawn as aviation fuel prices decline from record highs.

The cost of food in the supermarkets is also heading lower – notably for beef and chicken but also (notes the Statistics Commission) a supply of cheaper biscuits onto the shelves …. A small crumb of comfort during difficult macroeconomic times.

But to make the call for imminent price deflation at a time when the annual rate of inflation is still more than twice the government’s target of 2.0% is premature.

Much of the reduction in inflation is simply the result of hefty price rises this time last year falling out of the inflation calculation.

And whilst the recession is leading to widespread price discounting – from the internet to the shopping malls, don’t forget that the weakness of the pound will cause a rise in the cost of imported products – from finished DVD players and cars to the prices of essential components and basic raw materials.

We are still seeing inflation in the prices of tangible goods at a rate higher than 4% and there seems little noticeable cut in the inflation in the service industries.

Yes inflation will fall as real output declines (the output gap will become negative in 2009) and fewer people are in work.

But outright price deflation is extremely rare in modern economies where both consumers and businesses have well embedded and positive inflation expectations.