Inflation? Deflation is the danger

In the Sixties and Seventies the Financial Times commentator C Gordon Tether would entertain readers with the proceedings of the Hetheringstoke Academy for Central Bankers.

It was a fictional establishment, but the reports of the imaginary goings on had a ring of truth about them - so much so that a Japanese reader wrote to the FT for the address of the great institution, no doubt thinking it could plausibly be situated somewhere between Heathrow and Basingstoke.

One of Tether's themes was the language central bankers resort to in their perennial quest to combine meaning with discretion. I am reminded of this by the number of questions I have received about why the Bank of England seems recently to have sung two tunes - one suggesting that the strength of consumer spending and house prices is such that the next move in interest rates may be upwards; another that the markets - eager for 'recovery' - have got it all wrong and that the direction is far from assured.

In a speech last Monday the Governor appeared to be trying to calm speculation about rate increases. Sir Edward George said that 'when it becomes clearer that the international environment really is improving and that external demand really is picking up, we can look forward to better balanced growth

'That will in due course mean that domestic demand growth - and consumer demand growth in particular - will need to moderate if we are to avoid a build-up of inflationary pressure.'

But he emphasised: 'Let me be quite clear - that's not a warning, still less is it a threat. It really is a matter of arithmetic! It's quite possible that the necessary moderation of consumer demand will come about of its own accord.'

Indeed, he said, 'given the gradual increase in unemployment ... and the build-up of household debt, that would be the best possible outcome'. But if consumer spending were not to moderate of its own accord 'we would clearly need at some point to consider raising interest rates, to bring about that moderation'. He then added: 'I do not suggest that the timing of any such move is imminent'.

George was speaking shortly after the Monetary Policy Committee had elected to leave interest rates where they were. Although I always emphasise to people that you can never be quite sure what a committee of nine will come up with, that 'no change' decision was a racing certainty.

In one corner the MPC had retail sales rising more rapidly than at any time since the Lawson Boom of 1988, and house prices still strong; this pointed to a rise in rates.

In the other corner was the very strong pound and the dreadful performance of manufacturing output - pointing to the need for another reduction in rates.

The begged question, of course, is the improvement in the international environment. Here again we find ambiguity in the interpretation of central bank comments. Thus, in his capacity as chairman of the Group of 10 leading central bankers. George spoke so guardedly on 7 January that the following day the FT headline was, 'G10 banks upbeat on prospects for recovery', while the Times told us: 'Governor warns investors over recovery hopes'.

When talking about a general world economic recovery people focus on the US. That master of the sort of central bankspeak associated with Hetheringstoke, Alan Greenspan, said on 11 January: 'Arguably, our economy has not been weakening cumulatively in recent weeks.' What a great sentence! He then looked at the pros and cons of the possibilities for recovery, and seemed to me to come down on the pessimistic side.

Central to his analysis is that 'the broad contours of the present cycle have been, and will continue to be, driven by the evolution of corporate profits and capital investment.' During the upswing, capacity grew faster than demand, exerting 'severe' pressure on prices and profits. The next phase of this oldfashioned business cycle was cutbacks in capital spending, interacting with, and being reinforced by, falling profits and equity prices.

The nub of the matter is: 'A striking feature of the current cyclical episode relative to many earlier ones has been the virtual absence of pricing power across much of American business,' says Greenspan.

In the globalised, deregulated world, competition is fierce, and businesses have 'very little capability to pass cost increases on to customers'. Instead, business managers 'have moved aggressively to stabilise cash flows by trimming workforces'. While seeing hope in the long term, Greenspan 'would emphasise that we continue to face significant risks in the near term. Profits and investment remain weak'. Without being specific, Greenspan gave the impression he thought the markets were displaying - well, how about 'irrational exuberance'?

Two interesting studies from Stephen King at HSBC ('Decline and Fall - Bubbles, Busts and Deflation' and 'Global Economics - It's recovery, but not as we know it.') have impressively emphasised the global economic risks. King concludes: 'Collapsing private sector expectations and indications of policy failure suggest that a return to the heady growth of the late Nineties - particularly in the US - is still a long way off.'

Central banks, he suggests, will focus on 'the avoidance of deflation'. (I hope the European Central Bank reads King).

In the UK, manufacturing has been in recession for some time, and there are now worries about a slowdown in services. The MPC in December was concerned that, if it did not do enough to support domestic demand, output growth would 'dip further below trend', and inflation 'further below target.' If it did too much, there would eventually be a collapse of consumer spending, and that, too, would 'create difficulties in meeting the target'.

Beneath our frothy consumer boom, exports fell at an annual rate of 14.5 per cent in the third quarter of 2001, and manufacturing output plunged at an annual rate of 7.5 per cent in the three months to November. The Ernst & Young Item Club points out: 'The main concerns are the danger of the divided economy and the likelihood that inflation will undershoot the 1.5 per cent target lower band.'

As Item economist Peter Spencer says: 'The time could not be better for the MPC to start talking the pound down, supporting the move by selling sterling.'

This might help the British economy to experience a little more production and to live less on the never-never.

In line with another post of mine a few minutes ago, where I predicted deflation over the next decade, here's another article (a few months old now) saying the same thing. Search for "deflation" on FreeRepublic.com, and you will find a few more such articles over the last half year.

Note the Greespan quote: 'A striking feature of the current cyclical episode relative to many earlier ones has been the virtual absence of pricing power across much of American business.'

The debate over inflation/deflation is fundamentally flawed because the effects (price increases/decreases) are confused with the thing itself. If prices for consumer goods fall and the money stock is still constant, it is because of either increased supply or reduced demand. Producers or consumers are in the process of correcting prior errors (over-capacity, working off debt, etc.) The question is what caused the prior errors and the answer, invariably, is poor decisions incentivized by inflation, i.e., an increase in the money stock.

The column is a prime example of the essentially anti-free market stance of modern economics. They conceive the economy as some sort of a precision machine isolated from individual actions which must constantly be fine-tuned by the "experts."

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