Abu Dhabi, UAETuesday 11 December 2018

'Real' deflation is the real worry for world economies

In the topsy-turvy world of economics, it was not too long ago that people and companies in the Gulf were lamenting large rises in commodity-fuelled inflation.

In the topsy-turvy world of economics, it was not too long ago that people and companies in the Gulf were lamenting large rises in commodity-fuelled inflation, but are now looking back with nostalgia at those days compared with the more frightening prospect of downturns, recession and deflation. It is now official around the world, with the UK and Japan announcing the largest deflationary period since the 1950s and jeopardising prospects for revival, while Gulf economies have slashed their inflation rates to levels of 2007.

Central banks around the world face a quandary with no room left for cutting interest rates, and discussion has refocused on how better to communicate policy. Spurred by persistent disinflationary impulses and concerns about deflation, the main concern now is installing confidence that growth has begun. Some central banks such as the Federal Reserve view this as an opportunity to reopen debate on the value of an inflation target. More, however, agree that simply being more explicit about the Fed's longer-term preferences for an inflation rate would be of most benefit to help prevent the risk of deflation in this environment.

The issue the Fed has yet to settle is how to express that preference. When prices are falling, the Fed is aware of the credibility gap in talking about an inflation preference that is so at odds with statistical reality. But officials believe it would be appropriate to express a preference for inflation to be in a longer-term range of somewhere above zero. When the Fed took its interest rates to almost zero levels, it spoke of the need to "preserve price stability". In this context, preserving price stability means acting to prevent prices from falling.

It is not that the Fed has spotted specific data indicating growth in the US economy. Rather, it is a view that, as bad as conditions are, they are not getting precipitously worse. Among more sanguine officials, there is an expectation that a slowdown in the deterioration of the housing and labour markets mean they will no longer detract from the economy's performance. This is what they called "deceleration of the negatives". Remove the negatives and add minor positives from stabilising consumption and there could be anaemically upbeat data outcomes.

Deflation can be cancerous for companies, as Japanese firms and their government found to their cost in the late 1990s and early years of this century. It seems to have the quality of a doomsday scenario to it - downward spirals that are difficult to stop, and it is not technical deflation that is worrying, but real deflation. Technical deflation is a few months of a falling retail index. Real deflation is scarier - when companies that have fixed higher interest rate debt on their books are forced to set aside ever greater amounts of capital to service the debts in the face of declining sale prices.

The same applies for fixed rentals and any other fixed obligations. The nightmare scenario of deflation is of a rise in the real value of debt as prices fall, triggering a downwards spiral of mass insolvency, falling demand and further deflation. In the Gulf, this has started to affect construction companies and those that had relied on a continuous rise in asset value. None of these outlooks is without caveats and no one foresees actual economic momentum until the financial system finds its feet. Most important, recovery is not expansion. Similarly, in the labour market some officials see signs suggesting the worst of the job losses may have ended. Major job shedding occurs typically at the beginning of a recession, so the huge non-farm payroll monthly slumps coming in now are more likely due to stagnant job creation and the typical churning that occurs in this part of the cycle. By the start of spring next year, some officials believe this phenomenon will be clearer in the data.

Other factors that can contribute to a recovery this year include the recent period of lower oil prices and additional stimulus from the Obama administration. Fed economists have no way yet of determining what the ultimate impact will be on GDP until any package is finally passed. Instead, they expect the sheer magnitude of any comprehensive fiscal response will transmit into the economy and boost consumer confidence.

Still, even if all the building blocks for recovery fall into place, many are nervous about lurking external clouds such as collapsing emerging markets. Another European downturn would put back prospects of a US recovery into next year at best. Equally, while private-sector forecasters race to predict the lower limits of China's slowdown, US policy officials are mindful that China has the potential to knock the wind out of America's sails. Ultimately, Fed officials recognise there is no meaningful or sustainable recovery without the global financial system getting back on its feet.

Public sector solutions, be they via government or the central bank, must run in tandem, be comprehensive and deal with the root problems at the core of the global financial crisis. In the meantime, consumers around the world, and in the Gulf, are enjoying a bout of deflation. Dr Mohamed A Ramady is a former banker and visiting associate professor, finance and economics, at King Fahd University of Petroleum and Minerals, Dhahran, Saudi Arabia.