Hamish McRae: Why we don't always need to fear zero inflation

A different point of view: How damaging would a period of a falling prices really be?

David Gray/Reuters

7 March 2016

For anyone who can remember the Seventies and Eighties, it should seem bizarre that central banks are fighting to create inflation.

In 1975, the worst year, the retail price index rose by 24.9% and, although it fell back a bit through the Eighties, in 1990 it was back up at 9.3%.

It was a world where some people tried to renegotiate their pay every three months and where, in 1981, a 10-year fixed rate mortgage cost 18%.

Yet this Thursday, the European Central Bank is widely expected to bring in some sort of stimulus partly to boost prices — for inflation in the eurozone fell to minus 0.2% last month — and partly to jack up some growth.

It will expand its quantitative easing programme, buying more assets in exchange for cash, and cut its deposit rate, probably in some tiered way.

Since the ECB deposit rate — the rate it pays to banks to hold money with it — is already minus 0.3%, it faces a conundrum. If a negative rate has failed to generate inflation, would making it yet more negative do the trick? Might it actually make matters worse?

The idea is to get banks to lend the money instead of leaving it with the ECB. But since the banks cannot impose a negative rate on depositors (one or two have tried), it just squeezes their profitability and may make them even more cautious.

Problems with prices: ECB president Mario Draghi

Ralph Orlowski/Reuters

When the Bank of Japan unexpectedly introduced negative rates last month, the markets — far from welcoming the move as a way of boosting confidence — actually plunged, consumers hated it, and the governor was hauled over the coals in the Diet.

There are two ways of looking at this. One is to say, well, if monetary policy is not working, we need to fine-tune it to make it more effective. You should also buttress policy by having governments take additional fiscal measures, such as investing in infrastructure, to generate more economic growth. That is the mainstream response and we are going to hear a lot more of it in the coming weeks.

Mercifully in the UK, or indeed the US, we are not quite in the position of the eurozone or Japan. There has been a decent economic recovery in both countries (though the latest data here are a bit worrying) and there is some underlying inflation at a consumer level.

Expect the recent fall of the pound against the dollar to push up prices a bit more. Still, concerns about deflation both here and in the US do linger.

The other way of looking at this period of zero or negative inflation is to ask whether it matters. Would a world of stable prices be such a bad thing? The present view that there should be some inflation — around 2% — is a new idea.

Targets for inflation only came in as a result of the searing experience of the Seventies and Eighties, when the central banks had lost control and the very fabric of our societies was threatened.

For long periods in the past, including times of solid growth, there was no overall change in price levels. People did enjoy an increase in their living standards but these came through as much from lower prices as from higher incomes.

Indeed, you could argue that it is fairer for society to get the benefits of growth through lower prices because everyone shares in that. If the benefits come in higher wages, the unwaged lose out.

You can catch a glimpse of the way a world of falling prices benefits everyone by looking at what has happened in information technology. It is not just that the price of a mobile phone has fallen as its competence has increased.

Many of the apps you “buy” to use on that phone come free. In that particular segment of the world economy, deflation is extreme. If you adjust for quality, prices fall relentlessly year after year. Yet no one worries about that; in fact most of us welcome it. So why should we worry about the very small declines that have come through in overall consumer prices in recent months?

I think the answer is that the most recent period of sustained deflation, the Thirties, was indeed a time of profound economic disruption and distress. That shadow hangs over our policy, as indeed it should. But you can argue, I think persuasively, that deflation then was more the result of the disruption than the cause of it.

In any case, there is another period when the long-term trend of prices was downwards, which saw huge economic progress worldwide. It was the last great burst of globalisation that took place from the 1820s through to 1914.

We know a lot about it. We know that prices in the UK on the eve of the First World War were roughly the same as they had been 100 years earlier, although of course the basket of goods and services people could buy was vastly different.

We know there were huge disruptive swings in the business cycle. We know about the misery of working conditions, and we know, looking around the world, of the exploitation of the European colonial empires.

But — and this is the big point — overall living standards in the developed world rose at a rate that had never previously occurred in human history.

To say all this is not to welcome deflation now. It is just to say that we are far too frightened of it, and the cure — ultra-low interest rates — might turn out to be worse than the disease.

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