Page last updated at 17:05 GMT, Tuesday, 18 November 2008

Is there a danger of deflation?

By Hugh Pym
Economics editor, BBC News

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Recessions have a habit of pulling down prices

Deflation - it sounds scary. And it could be.

It's a measure of how dramatically the outlook has changed that the D word is now being used extensively (even by the Prime Minister) just a couple of months after rising inflation appeared to be the main threat.

And let's not forget that, although it has fallen sharply, inflation is still at 4.5%, well above its 2% target.

Deflation means falling prices.

That does not have to be a problem if it lasts just a few months and no more.

Record declines

We have not seen the retail prices index (RPI) falling for a period of a year since 1960.

But there was no long term damage to the economy then, just something of a slowdown.

The Bank of England has predicted that inflation on the RPI (the wider measure which includes mortgage payments) will slip below zero sometime next year.

That is in part an arithmetical consequence of falling interest rates, as the RPI will to be pulled down by lower mortgage costs.

The Bank of England, however, targets the Consumer Prices Index (CPI), which it aims to keep at 2%.

According to the Bank, CPI inflation is expected to fall quickly from its current 4.5% level inflation to around 1% by sometime next year but will probably stay above zero.

Inflation nightmare

All this is a big worry for the Bank.

Their inflation nightmare has turned into a deflation headache, all in the space of a couple of months.

CPI inflation falling significantly below the target is as much a problem as it was when far above the target this year.

The target is symmetrical and the Bank is obliged to use interest rates to try to lower or raise inflation.

If the Bank was offered zero inflation for a while and growth picking up towards the end of next year it would take it now.

That would involve some pain to the economy but not as much as the gloomier forecasters envisage.

What policymakers are desperate to avoid is a sustained period of falling prices.

Japanese nightmare

The Japanese experience is often quoted as a case study of how governments and central banks should not behave in a downturn.

Falling property prices and corporate failures in the early 1990s were not matched with early government action. Fire sales of assets made an already weak market even worse.

When the government did implement tax cuts and spending increases, and the central bank slashed interest rates, it didn't make much difference.

By the time Japan's banks had cleared their balance sheets of bad loans and owned up to their losses, it was too late.

From 1999 deflation set in, with persistently falling prices. Interest rates fell to zero but the economy stagnated.

If prices are falling, buyers hold back in expectation of yet lower prices and a downward spiral is generated.

Japan did not see positive inflation again until 2006.

Avoiding Japan's "lost decade" is now the over-riding priority for the Treasury and the Bank of England.

That's why a fiscal boost involving tax cuts is being planned by Downing Street following the Bank of England's big interest rate cut.

Lessons learned in Japan include the need to act early and make bold policy moves.

The chance of the UK following the Japan experience is low.

But the fact that it is being discussed at high levels is a measure of the concern about the dangers of the D word.

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