Evil twins stage comeback

27th October 2010

To help make sense of the complexities of inflation and deflation, known as the evil twins in times of acute economic crisis, Mindful Money interviewed John Anderson, head of credit at Gartmore.

Inflation

Q: What causes inflation?

JA: There are two theories as to the causes of inflation- it comes from demand pull, or cost push. Cost pull is where inflation comes about as a result of an increase in the cost of goods from the rising cost of production. Demand push is where too much money is chasing too few goods. The latter is by far the more commonly accepted explanation.  

Q: When does it become a problem?

JA: Inflation becomes a problem when the real value of money starts to deteriorate. At that point it starts actively to destroy wealth. The crucial element is wages. Inflationary cycles can build up whereby 20% inflation leads to demands for a 20% rise in wages. The producer has to put prices up to reflect his higher input costs. In the UK, we have largely managed to break this cycle.

Q:What can be done?

JA: Interest rates are the traditional way of controlling inflation because they can help control demand. If you raise rates, it curtails people's ability to spend. It is not a perfect system. Commodity demand in China, for example, can create inflationary pressure in the UK and interest rates cannot address that. However, it can help avoid the spiral.

Now, because of globalisation, more flexible labour markets and less unionisation, UK employers won't pay staff extra simply because they demand it. It may become a problem in times of full employment, but now labour is commoditised. If wages go up, the call centre moves to India.

Q: How is it measured?

JA: Inflation is measured via RPI and CPI. The RPI tends to be higher and takes in a measure of housing costs. CPI is a European-wide formula. No agreement has been formed on how to accommodate the different housing calculations for different countries, so it is left out.

Deflation

Q: What is deflation?

JA: Deflation is when there is not enough demand and too much capacity. Prices start to come down. This also destroys wealth in terms of the value of assets – property, wages, financial assets all fall – which has repercussions for confidence in the economy. What business would invest if, in one year, whatever they buy is likely to be worth less? This is why governments dislike it so much.

It can have a knock-on effect on wages. If companies can't sell their goods, they have to lower the price. To do this, they have to lower their costs, including the costs of labour.

Q: How often does it happen?

JA: It is a very rare event. They have had it moderately in Japan. It is rare because it is relatively easy to reflate an economy. Japan had a perfect storm of an ageing population with a high propensity to save. That means that lower interest rates and fiscal stimulus all went in the bank. The currency was also very strong. One way of the ways to deal with inflation is to let the currency fall sharply, which reduces the cost of exports and raises the cost of imports.

Q: Is deflation likely in the UK?

JA: Not with the current measures pursued by the Bank of England. It has been said that the scale of costs in public spending will be deflationary. I think it will be disinflationary, but it is difficult to see price falls.

 

*Readers might also be interested in reading this article on inflation and deflation published by thisismoney.co.uk.

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