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Deflation – why is it a concern?

August 9, 2017 Leave a comment

Here is a good video from DW on deflation. Deflation is seen as negative for an economy for the following reasons:

1. Money made today will be worth less tomorrow so investment is discouraged
2. Goods cheaper tomorrow reduces consumption and therefore aggregate demand
3. Central banks struggle to set real interest rates which are stimulatory
4. People who borrow money find that what they owe is worth more in real terms
5. Demand runs below the economy’s capacity to supply goods and services leaving an output gap. This can lead to unemployment and wage cuts which worsens the situation

One of the main problems at present is the fact that Central Banks are running out of ammunition – interest rate cuts – as rates are close to 0%. Therefore in order to stimulate demand they now have to use fiscal policy and more government spending would assist especially in areas that are in need – e.g. roads, bridges etc.

 

 

Categories: Deflation

Deflation – Benign and Malevolent

May 29, 2017 Leave a comment

Just been covering this area with my AS class and below are some notes. First of all, we need to be clear as to what we mean by deflation. It is a fall in the general price level and must not be confused with falls in a few specific prices, such as for televisions and cars.

Economists distinguish between ‘benign’ deflation and ‘malevolent’ deflation.

‘Benign’ deflation usually stems from technological advances which bring down the price of products. Computer chips would be a good example and I am sure that you can think of others where goods that were initially very expensive have fallen in price as technology has progressed. As a result of the fall in these prices, real incomes have risen.

‘Malevolent’ deflation is the real problem. Here the money supply falls, aggregate demand falls and serious economic consequences may result.

The Consequences of Deflation
1  As aggregate demand falls, firms will find it difficult to sell their products, stocks will begin to rise and less production will be necessary. Firms may try at first to cut costs by wage reductions, but this strategy will be fiercely resisted by workers. The cuts, however, will become inevitable. Even this may not be sufficient and as the demand for goods and services falls, the demand for workers will fall and unemployment in the consumer goods and services industries will rise. The multiplier can work in reverse as well, so an initial fall in spending can trigger further falls in aggregate output.
2  Also, with consumer demand falling, firms will face decreased profits and also have poor expectations of future profitability. There is also a negative accelerator: falling GDP (a recession) hurts business profits, sales, cash flow, use of capacity and expectations. This in turn discourages investment.
3  As firms may have borrowed to invest in capital equipment in the past they will now be faced with the problem that the return on their capital spending is well below what they anticipated. With falling demand but borrowing costs rising in real terms as a result of falling prices, bankruptcies are likely to be a feature of deflation.
4  ‘Negative equity‘ is likely to depress consumer spending as people find that the value of their house falls and their debt or mortgage becomes larger in real terms.
It is the last that could be the real killer. Modern western economies have been built on an ever-rising quantity of debt. In the last decade, borrowers could rely on rising prices to inflate away the real value of their debts; now for the first time since the depression of the 1930s there is the looming threat of debt deflation, where the burden of debt grows bigger rather than smaller. It also means that real interest rates can’t be negative, and so are undesirably high. That spurs yet more repayment of loans so that the liquidation defeats itself.

In terms of policy, the risk of debt deflation will mean that economic policies remain looser for longer and even if inflation  remains low and recovery will be hesitant. However if the global economy fails to respond to the stimulus, they don’t have an awful lot left to offer. With deflation there is mention of a classic Keynesian liquidity trap.

The Liquidity Trap
This is a situation where monetary policy becomes ineffective. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. But John Maynard Keynes argued that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policy makers.
The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor.

liquid_trap
All increases in money supply are simply taken up
in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Consequently, monetary policy under these circumstances is futile.

Final thought
Today the threat of deflation seems to have passed us by but the world was looking at a major global slowdown and it was not a matter of how much things were slowing, but it was how much they were going backwards. The most disconcerting fact was that all the easing of interest rates by central banks didn’t really change that outlook. Besides, with the severe threat of deflation there was a need to preserve the firepower in case the economy needed more stimulating. Like when an individual is besieged by many attackers while holding limited ammunition, each shot is used sparingly. But with little ammunition left what was next?

Categories: Deflation

Global Liquidity Trap

April 4, 2017 Leave a comment

The FT had an excellent article back in April last year that covered many concepts which are a part of Unit 4 of the CIE A2 Economics course. It covers the liquidity trap, deflation, MV=PT, circular flow, Monetary Policy, Quantitative Easing etc.

The article focuses on the liquidity trap with Monetary Policy being the favoured policy of central banks. However by pushing rates into negative territory they are actually encouraging a deflationary environment, stronger currencies and slower growth.  The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.

Liquidity Trap

Normally lower interest rates lead to:

  • savers spending more
  • capital being moved into riskier investments
  • cheaper borrowing costs for business and consumers
  • a weaker currency which encourages exports

But when interest rates go negative the speed at which money goes around the circular flow (Velocity of Circulation) slows which adds to deflationary problems. Policymakers pump more money into the circular flow to try to stimulate growth but as price fall consumer delay purchases, reducing consumption and growth.

The article concludes by saying Monetary Policy addresses cyclical economic problems, not structural ones. Click below to read the article.

The global liquidity trap turns more treacherous.

Bank of Japan sits on its hands

May 15, 2016 Leave a comment

Central Bank Rates 6th May 2016Been teaching a lot on the problems that economies have in trying to stimulate more growth to get out of the deflationary threat that is prevalent in many countries. Central Banks around the world running are out of ammunition (cutting interest rates – see rates below) and one wonders what is the next step that economies can take?

Back in February the Bank of Japan (BOJ) pushed interest rates into negative territory with the uncollateralised overnight rate being -0.10%. After saying that it would do everything in its power to get inflation to reach 2% (its target rate) and with inflation expectations moving down from 0.8% to 0.5%, markets were very surprised that it didn’t ease rates further. Two of Japan’s measures of inflation are moving away from the the target rate of 2% – see graph below.

Japan inflation 2016

With this decision the Yen strengthened and it is becoming exceedingly difficult to tell if a central bank has run out of ammunition especially when it doesn’t fire a shot. So why have the BOJ held off on easing?

  1. When rates are cut – especially if they go negative – it takes six to twelve months to judge its impact on the economy. This is something referred to as the ‘Pipeline Effect’.
  2. Governor Haruhiko Kuroka may be concerned with the strengthening of the Yen after the last cut in February. This makes exports more expensive and imports cheaper.
  3. The Governor is waiting for the government fiscal stimulus to kick in with the impending cancellation of an increase in value-added-tax.

There is plenty of room to push interest rates further into negative territory and with the next scheduled BOJ meeting in June they will be watching what the US Fed reserve do. An increase in the US Fed rate will mean a stronger US dollar which might achieve more for Japan than further negative interest rates.

Low inflation in New Zealand not just about falling oil prices.

March 15, 2016 Leave a comment

The 0.1% inflation rate in New Zealand has largely been attributed to the 50% drop in oil prices since the start of last year – see chart. Although oil prices are referred to as a volatile item they have been low for sometime and are expected to remain subdued. Lower fuel costs have reduced prices for services such as air travel, and have dampened prices on shop floors as the distribution costs for retail items have declined.

World Commod Prices

However low inflation doesn’t just reflect movements in the price of oil. Even excluding petrol prices, inflation has been below 1% for most of the past year, and it’s set to remain low through 2016. The weak inflation figure has also been due to the low global inflation holding prices down and with the trend likely to continue for some time given the deterioration in global trade and widespread falls in commodity prices. Add to this the slowing growth of the Chinese economy and with its importance to global growth (see chart) you have a serious threat of deflation. This is particularly a concern if the Chinese authorities decide to further devalue their currency – the Renminbi. The RBNZ will have a tough job ahead of it to generate a sustained increase in inflation.

Screen Shot 2016-03-13 at 11.48.53 PM

Winners and Losers of lower oil prices

January 22, 2016 Leave a comment

With lower oil prices below is a table looking at the winners and losers.

Oil - Winners Losers

Categories: Deflation, Supply & Demand Tags:

Supply Side policies Chinese style

January 11, 2016 Leave a comment

The names of Reagan and Thatcher are identified with supply-side policies of the 1980’s in the US and the UK. Now the Chinese authorities are suggesting the need to implement supply side policies as the country looks poised to post its slowest annual economic growth rate in a quarter century.

During the 1980’s the concern in the US was production bottlenecks fuelling inflation and stifling growth. However, in contrast the Chinese have the opposite issues – excess production, the threat of deflation and unsustainably rapid growth. In classic supply-side economics, the government should reduce its role in economic activities, but in the Chinese context, the government will continue to play a big role in making supply-side changes.”

The differences between US and Chinese Supply Side Policies

US v China supply side

Categories: Deflation Tags: ,

Sweden’s negative interest rates.

November 15, 2015 Leave a comment

To boost spending in any economy you would assume that the central bank would reduce interest rates – encourages borrowing and reduces saving. But very low interest rates could encourage people to hold cash rather than keep the money in the bank – this could slow economic activity in the economy.

Sweden’s central bank – Riksbank – has gone negative with interest rates. Sweden has the third highest savings rate in the developed world but there is a significant positive output gap. With inflation at 0.2% it remains well below the central bank’s 2% target but the mandate from the Swedish government encourages radical measures to rectify the threats of deflation. 

But with lower rates in the eurozone to stimulate growth this has weakened the Euro against the Swedish krona making Swedish imports cheaper and putting further deflation pressure on the economy. Therefore the Riksbank has had to cut its own rates in response in an attempt to avoid deep deflation. Switzerland has also go the negative way with a rate of -0.75%.

Swedish Interest Rates

OECD Deflation

January 7, 2015 Leave a comment

In 2014, 9 of the 34 members of the OECD experienced deflation whilst 3 others had zero inflation. Over the whole area consumer prices rose by only 1.7% mainly due to the fall in oil prices.

However in the Euro area inflation was only 0.4% over the year which is worrying especially as the European Central Bank (ECB) targets an annual rate of 2%. With interest rates at the ECB at 0.05% there is little scope for any stimulatory activity to increase inflation. Furthermore they are also charging banks deposits on money in the bank through a negative rate of 0.2%. Although lower oil prices will benefits businesses and consumers alike it maybe paradoxical if people expect lower inflation as cheaper energy pushes the headline rate into negative territory. So, the ECB has taken a leaf out of the US Fed’s book and decided on a form of quantitative easing by purchasing covered bonds and asset-backed securities.

Mario Draghi, President of the ECB, has not ruled out using additional measures “should it become necessary to further address risks of too prolonged a period of low inflation”.

Although Japan has an annual rate of inflation of 2.9% this has been largely due to an increase in the retail sales tax – if you exclude it from the calculation the inflation rate would be 0.9%. The Japanese Central Bank has a target of 2% inflation. As with the ECB interest rates in Japan are very low – 0.1% – so this leaves no scope for any stimulatory cuts. They are hoping that a further stimulus package of ¥3.5 trillion (NZ$ 37.41billion) on 27th December will boost the economy.

In New Zealand the annual inflation rate in September was 1% – the Reserve Bank Act 1989 stipulates a band of 1-3% while targeting future inflation at 2%. Unlike their counterparts at the ECB and the Bank of Japan they do have scope for stimulatory cuts as the official cash rate is currently 3.5%.

Deflation OECD

Categories: Deflation Tags: , , ,

The Perils of Deflation

December 18, 2014 Leave a comment

DeflationFor so long central banks and policy makers have been obsessed with inflation but with inflation falling the dangers of deflation are now on the horizon. In the USA, Britain and the euro zone inflation is dropping below the 2% target and Japan is struggling to maintain higher prices. Why is deflation bad:

1. Money made today will be worth less tomorrow so investment is discouraged
2. Goods cheaper tomorrow reduces consumption and therefore aggregate demand
3. Central banks struggle to set real interest rates which are stimulatory
4. People who borrow money find that what they owe is worth more in real terms
5. Demand runs below the economy’s capacity to supply goods and services leaving an output gap. This can lead to unemployment and wage cuts which worsens the situation

One of the main problems at present is the fact that Central Banks are running out of ammunition – interest rate cuts – as rates are close to 0%. Therefore in order to stimulate demand they now have to use fiscal policy and more government spending would assist especially in areas that are in need – e.g. roads, bridges etc.

Would US public infrastructure spending drive up prices?

Some alarming figures have been banded about with regard to America’s infrastructure. It is estimated that over 700,000 bridges are rated as structurally deficient. In 2009 Americans lost approximately $78 billion to traffic delays – inefficient use of time and petrol costs. Also crashes which to a large extent have been caused by road conditions, cost a further $230 billion.

According to the American Society of Civil Engineers the US needs to spend $2.2 trillion bring their infrastructure up to standard. The Congressional Budget Office estimated in 2011 that for every dollar the federal government spent on infrastructure the multiplier effect was up to 2.5. Other indicators state that every $1 billion spent on infrastructure creates 18,000 jobs, almost 30% more than if the same amount were used to cut personal income taxes. – The Economist

Positive Externalities from infrastructure.

Investment in infrastructure has a lot of positive externalities – faster traveling time for consumers and companies, spending less time on maintenance. Research has shown that the completion of a road led to an increase in economic activity between 3 and 8 times bigger than it initial outlay with eight years after its completion. But what must be considered is that now is the best time to invest in infrastructure as it is very cheap – much cheaper than it will be when the economy is going through a boom period.

Deflation fears on the agenda once more

October 19, 2014 Leave a comment

Deflation has emerged as a major risk to the global economy with it being particularly evident in Europe and Japan where leaders have found it hard to come up with any solutions to generate economic growth. In Europe inflation was just 0.3% in September well below the 2% target of the European Central Bank. With this low rate any weakness in the Germany economy could tip the Euro economy over the edge into a deflationary downturn. The extent of the concern with deflation was evident by the ECB’s record low interest rates – 0.05% – and a negative rates for deposits. With austerity measures in place in France and Italy one wonders about their ability to bring about any sort of growth and ultimately some mild inflation.

Deflation Oct 2014

Why is deflation a concern?

1. Holding back on spending: Consumers may opt to postpone demand if they expect prices to fall further in the future

2. Debts increase:

• The real value of debt rises when the general price level is falling and a
higher real debt mountain can be a drag on confidence
• Mortgage payers on fixed mortgage interest rates will see the real cost of servicing their debt increase

3. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices

4. Lower profit margins: This can lead to higher unemployment as firms seek to reduce their costs.

5. Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence – leading to further declines in AD. Higher savings can lead to the paradox of thrift

Source: Tutor2u

Categories: Deflation Tags:

Deflation threat for Euro area

January 17, 2014 Leave a comment

Today inflation in the Euro area is at dangerously low levels – 0.8% in the year to December. This is well below the target of 2% set by the European Central Bank. It doesn’t help that unemployment in the area is 12.1% and this will need to fall if there is to be some sort of recovery which will put upward pressure on prices. The ECB cut its Main Refinance Rate to 0.25% on 13th November last year and could be running out of options. It might be looking at imposing negative interest rates on deposits held at the ECB by trading banks.

Euro Area Inflation

Why is deflation a concern?

1. Holding back on spending: Consumers may opt to postpone demand if they expect prices to fall further in the future

2. Debts increase:

• The real value of debt rises when the general price level is falling and a
higher real debt mountain can be a drag on confidence
• Mortgage payers on fixed mortgage interest rates will see the real cost of servicing their debt increase

3. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices

4. Lower profit margins: This can lead to higher unemployment as firms seek to reduce their costs.

5. Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence – leading to further declines in AD. Higher savings can lead to the paradox of thrift

Source: Tutor2u

Categories: Deflation, Euro, Inflation Tags:

Japan pours more fuel on the ‘dull’ embers

November 1, 2012 Leave a comment

The New York Times recently reported that the Japanese authorities are once again trying to stimulate a rather moribund economy with injecting more money into the circular flow.

* A ¥11 trillion is to be added to an asset buying programme
* The Bank of Japan will supply banks with cheap long-term funds in the hope of stimulating borrowing.
* Base interest rate to stay at 0-0.1% – see graph below
* These measures will stay in place until inflation has reached at least 1% – Bank of Japan forecast of this figure is March 2014.

There has been some return to growth with the reconstruction after the 2011 earthquake and tsunami. However global demand has declines and the issue of territory with China hasn’t helped – Japanese goods are not being favoured by Chinese consumers. Japan’s deflationary decade hasn’t been helped with a contracting population and monetary policy needs to be accompanied by government fiscal policy as private sector companies don’t have the confidence to invest in major expansions. To this end the government have thrown money at the economy to the tune of ¥422.6 billion (in the form of government spending) but this is already twice the size of the Japanese economy. A strengthening yen hasn’t helped matters as exporters find their products uncompetitive.

Deflation for New Zealand Economy?

July 17, 2012 Leave a comment

The recent CPI figures published by the Dept of Statistics in Wellington show that there was a 1% in the CPI from the June 2011 quarter to the June 2012 – the lowest annual rise since 1999. This is at the bottom of the Policy Target Agreement which stipulates that the CPI should be kept between 1-3%. The question now is whether annual headline CPI inflation can avoid dipping below the bottom of the 1.0% and whether the threat of deflation is a serious concern?

Deflation – why is it a concern?

In the short-term a period of deflation can help the economy. Falling prices mean that consumers can buy more with their income and rising purchasing power would provide a boost to confidence and could assist the economy by increased growth.

However a longer period of deflation can be very damaging to an economy for two reasons:

1. Expecting prices to be lower in the future consumers put off purchasing goods and services in the expectation that they will get lower. This leads to a contraction of demand and ultimately lower growth. Japan in the 1990’s is a good example of this – see graph below.

2. A more dangerous scenario is debt deflation. As prices fall the real value (nominal – CPI) of debt increases – just as it decreases if prices are rising.

The increase in debt that people have taken on over the last 5 years makes this latter point very worrying. However, commentators have suggested that deflation shouldn’t become a problem in NZ.

NZ economy strong despite Christchurch earthquake

July 16, 2011 Leave a comment

The 2011 March quarter GDP figures were quite amazing when you think of the tragic earthquake in the Christchurch area last February. The economy grew 0.8% (0.4% forecast) which signifies that the economy outside of Christchurch is very strong. If you compare the data from the other recent natural disasters, being the Queensland floods and the Tohoku earthquake/tsunami, New Zealand has actually grown – see figures and graph below:

* Australia had a 1.2% drop
* Japan had a 0.9% drop


The NZ$ and QE3

Also the NZ$ keeps motoring ahead – yesterday reaching US$0.85. However, with the official cash rate at 2.5% one wonders what is the currency reacting to? Most likely it was:

*the better than expected Q1 GDP figures outlined above and
*the words of US Fed Chairman Ben Bernanke who strongly suggested the US economy was in need of some more serious antibiotics in the guise of QE3 – Quantitative Easing 3 in which the Fed bascially print money.

Bernanke indicated that QE3 would depend on two conditions, economic weakness beyond current expectations, and a renewed threat of deflation.

The Fed is charged by Congress with minimizing unemployment, and some of its critics say that current unemployment rate of 9.2 percent should be a sufficient reason by itself for the central bank to expand its roster of economic aid programs.

Mr. Bernanke noted that the scale of the Fed’s existing efforts was unprecedented. The central bank has kept short-term interest rates near zero for more than two years. It also owns more than $2 trillion in mortgage-backed securities and government debt, the legacy of its two asset-purchase programs to reduce long-term interest rates.
New York Times

Future worry for NZ economy
These figures indicate strong underlying growth in the NZ economy but there are concerns about capacity contraints if the economy is to grow more. And if this is the case there will be significant pressure on prices and a sooner than predicted OCR increase by the RBNZ.

I am off on holiday for a week and will resume service on Monday 25th July.

Inflation: what you need to know

February 16, 2011 Leave a comment

The Guardian newspaper recently produced a useful article about inflation. Although UK based it covers issues such as: stagflation; a historical look at inflation globally (see below); is high inflation good for anyone; why do governments target inflation. Click here for the article.

Global Inflation
The record of the highest inflation globally was long held by Germany in the Weimar Republic years when money was carted around in wheelbarrows. In December 1923 prices were more than 85,000,000,000% higher than a year earlier and the highest denomination bank notes had a face value of more than 1,000,000,000,000 marks. In post-revolution Russia, inflation reached 60,804,000% that year – some economic historians believe the government deliberately stoked inflation to impoverish the better off.

But after the second world war, Hungary suffered the highest inflation ever recorded. In the peak month of July 1946, prices were doubling in little more than 12 hours. Other countries that have seen sky-high price rises include China during the civil war from 1945 to 1949, Greece in 1944, Argentina in the 1980s and war-ravaged Yugoslavia in 1994.

More recently, Zimbabwe made headlines for soaring inflation, with price rises hitting 66,212% in December 2007 – the highest inflation in the world at that time. The highest denomination bank note had a face value of 10,000,000 Zimbabwe dollars.

By contrast, Japan experienced a long period of deflation during the “lost decade” of the 1990s.

Bernanke’s history lesson to Japan – it could be useful!

October 15, 2010 Leave a comment

From the Wall Street Journal – criticisms Ben Bernanke made of Japan’s central bank a decade ago—saying it was too timid in stimulating Japan’s economy to prevent deflation—give hints of what the Fed’s next steps might be. As a Princeton professor in the 1990s, Ben Bernanke lectured Japanese officials for mishandling their economy. In a 1999 paper, Mr. Bernanke lashed out at Japanese officials, saying their country’s woes were the result of their own “self-induced” paralysis. Japan’s responses to deflation, he charged in atypically blunt terms, were confused, inconsistent and too cautious.Today, Tokyo’s economic problems are more than academic for the Federal Reserve chairman. They are a window into his own situation as he stares at what could be a long period of slow growth, high unemployment and declining inflation in the U.S. There are two lessons from the Japan experience:

1. be aggressive about providing stimulus to the economy in the early stages of a downturn and
2. avoid canceling it too soon.

Click here for the article in the Wall Street Journal. Also an informative interview with columnist Jon Hilsenrath

Categories: Deflation Tags: ,
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