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21 Jun 2024 11:08
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  •   Home > News > Business > Features

    Inflation versus deflation?

    There has been a hullabaloo in the media recently about prices falls. The UK's retail price index fell by 0.3% in March, the first decline since 1960. Meanwhile the Bank of England says the consumer price index (CPI) is likely to fall to zero and stay there until 2011.

    Investment Research Group
    Investment Research Group
    In the US, the CPI fell by 0.1% in March, the first annual decline in more than 50 years, bringing the annual rate to 0.4%. In NZ, prices are also falling but our price inflation is still running strongly at 3% plus.

    In response to this news, many commentators have referred to the prospect of deflation. But hang on a minute. Prices going down; isn't that a good thing?

    The concept that deflation means prices going down is a fallacy. Both the terms inflation and deflation refer to the amount of money in an economy. If the amount goes up, usually by a central bank creating it from thin air, this usually leads to higher prices over time.

    If the amount goes down, the reverse occurs. US commentator Steve Saville has recently produced a thoughtful and clear summary of the impacts of increasing the money supply. He says there are three effects. The first one is that whoever creates new money is able to use it to buy goods and services, this reduces the pool of wealth accessible to holders of the 'old' money, making them poorer.

    Second, too much easy money tends to lead to poor investment decisions and often outright speculative bubbles. Third, an inflation in the money supply eventually results in a broad-based increase in the CPI.

    "Almost everyone focuses on the third of these effects, but the greatest injustices and economic problems result from the first two.” He believes that the massive monetary inflation that has occurred in most western economies over the past several months probably will only start to drive up CPI items in 2010.

    For the rest of 2009, prices could even keep on declining. "This will make the deflationists look right for the next few quarters even though they will be wrong.

    They will be wrong because even while prices decline, the inflation will be taking a heavy toll on the economy by facilitating the transfer of resources to the government and to failed businesses," he says.

    Another commentator, Michael Pento, notes that central banks like the US Federal Reserve are trying to pump up economies by increasing the availability of money and credit (liquidity) with a view to reigning in price inflation once it shows itself.

    "The Fed's challenge in the long term will be to remove that liquidity without destroying the economy in the meantime, a nearly impossible task. If [Fed chairman Ben] Bernanke and company cannot shrink the balance sheet once banks begin to lend with abandon once again, the likelihood of hyperinflation skyrockets. Or if the government continues to print trillion-dollar deficits as far as the eye can see, the Fed will eventually create intractable inflation in order to diminish the value of that debt.

    These views support my own, that inflation in the medium term is more likely than deflation. As a result, readers might want to hang onto their resource and commodity investments, even though many have been trending down. I remain convinced their time will come again.

    © 2024 David McEwen, NZCity

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