Why is inflation so low?
Zero inflation is trending. The consumer price index in the UK was at the same level in February as it was a year earlier. The reporting of this figure on the BBC website created some unintended amusement, however. The drop to zero, we were told, was “sharper than many analysts had expected”. And what was this expectation? All of 0.1 per cent, almost identical to zero and, given the margins of error around these estimates, to all intents and purposes essentially the same figure.
Not only that, but the BBC solemnly informed us that the figure was the “lowest since records began in 1988”. Yet the Bank of England has recently released data which contains estimates as far back as the early nineteenth century.
To be fair, we do have to go back a long way to find an example of an entire year in which, on average, prices fell compared to the previous one. To 1934, in fact, though it was then nothing unusual. Inflation had been negative in every year since 1927. In the two other largest economies in the world at the time, America and Germany, inflation was below zero in every year from 1930 to 1933. Remember, though, that this was exactly the period of the Great Depression, when output fell by over 20 per cent and a quarter of the US workforce was unemployed. So we can see why prices fell. Demand for many products and services had collapsed.
The attitudes of the current batch of commentators and policy-makers have been shaped by the experiences of their formative years in the 1970s and 1980s. Inflation really was the number one problem then. Even in Germany, with its enormous fear of inflation ever since the early 1920s, when it briefly hit millions of per cent a year, prices doubled between 1970 and 1985. In Britain and the US, prices rose by more than 10 per cent a year quite frequently.
This was a very unusual period indeed. Sharp increases in prices were also experienced in the two world wars, when the economies were being run absolutely flat out. But over the past 150 years, during peace time in the US, UK and Germany, inflation close to zero has been the normal state of affairs. The basic reason for this is competition. Competitors are everywhere. They may be competitors which already exist, or they may only be potential competitors. In supermarkets, for example, Aldi and Lidl entered the UK relatively recently, spotting an opportunity to compete on price.
The downside of zero inflation is that it does nothing to erode the value of debt, much of which is denominated in money terms. If your mortgage is £100,000 and the price level doubles, its real value has fallen to only £50,000. The world is still burdened with excessive debt, which is a worry for policy-makers. But a low inflation world forces them to confront this issue honestly, and not try to evade it by using the subterfuge of inflation.
As Published in City AM on Wednesday 1st April 2015