Free exchange | Inflation

Are falling prices good news?

Looking more closely at recent inflation data




Is this news actually good? There are aspects of the news that are unambiguously good, from the perspective of the domestic economies of America and Britain. Headline inflation numbers have fallen in part because of a moderation in resource prices. That raises household spending power and removes a supply-side constraint on production. It should be good for growth right the way round. But the fall in prices—and declining annual inflation rates do represent an actual slide in many prices over the past few months—spans a broader range of goods and services than those directly affected by, say, the price of oil. And once we start thinking about the dynamics of these developments, the latest inflation news seems a bit less cheery.

Prices, remember, are determined by the interaction of supply and demand. Prices rise when there is excess demand for existing production, and they continue to rise if production is unable to expand in response to the price signal. This is how runaway inflation develops. Consumers find themselves with more money and take it to shops to spend it. If producers have too little inventory to meet demand, prices must rise to clear the market and producers will explore a production increase. If the economy is running at capacity, producers will struggle to raise output; to hire workers away from other firms or to retain their own employees wages must rise. Wage increases put more money in the pockets of workers, who take that money to stores to spend, and on the cycle goes. If the central bank does not intervene, then inflation expectations may rise and the process may accelerate.

If the economy is not at capacity, however, then rising prices will trigger increased production. Supply will rise to meet demand and, if the central bank wishes it, price increases eventually moderate. Moderation may tip over into outright decline; in some sectors, as I mentioned, this is beginning to occur. For prices to fall, there must be too little demand for current output. Falling prices are a signal to reduce production, which some firms may well begin to do. Reduced production might lead to layoffs, which can in turn lead to less money in the consumer's hand, which may in turn lead to further price declines and production cuts. (If prices and wages were perfectly flexible, then employment need not fall—prices and wages could adjust perfectly to ensure that resources are always fully utilised—but they aren't.)

In the long run, in other words, inflation is about the central bank's policy goals (and depending on the central bank's independence, about the conduct of fiscal policy). In the short run, inflation is both the result of shifts in aggregate demand relative to supply and the mechanism by which aggregate demand is increased (and more specifically by which the central bank raises aggregate demand).

That makes comments like this, on the economic situation in Britain, a little weird:

Rising U.K. unemployment is threatening to cancel the benefit of cooling inflation on consumer spending and keep the recovery in check this year, said economists at Citigroup Inc. and ING Group.

While Bank of England Governor Mervyn King says an easing of the price squeeze on consumers is one of the “good pieces of news” for 2012, its impact on household spending may be muted. Unemployment has risen to the highest in 16 years, wage growth is lagging behind inflation and consumer confidence is close to a record low.

“The fall in inflation will be very largely offset,” said Michael Saunders, chief Western European economist at Citigroup in London. “Unemployment is going to rise quite sharply and the key thing will be that real incomes are still falling.”

Again, inflation driven by supply constraints like dear oil and higher taxes placed a drag on consumer purchasing power while also cutting production potential. A broader decline in inflation, however, isn't good news that will be muted by rising unemployment. It is both a cause of and a direct result of rising unemployment.

To put it another way, inflation in Britain was observed to be rising above levels with which the Bank of England was comfortable. The Bank was reluctant to raise rates in order to slow inflation, because it observed that other sources of demand—in particular government spending—were going to fall sharply. The Bank was right; the British government has been trimming deficits quite aggressively, and public-sector employment is down by roughly half a million jobs. Government is taking money out of the pockets of consumers, who then spend less at the shop, which then translates into downward pressure on prices. Now ideally, workers sacked from government positions would be reemployed elsewhere, and the economy would experience a rebalancing rather than a recession. For that to occur, however, some producers must find it attractive to raise output by enough to add new workers. If sacked public-sector workers are willing to take enormous nominal pay cuts at new positions, then reemployment might well proceed amid moderating and falling prices, but there are lots of reasons to expect that workers will not be willing or able to accept sufficiently large pay cuts. And so to get rebalancing, at least some firms in the economy must see that excess demand that is represented by rising prices. Observers might have been perplexed to see the Bank of England begin a round of asset purchases while inflation was near 4%, but this is precisely why.

Similarly, it isn't a coincidence that American labour markets strengthened alongside rising core inflation. Higher inflation was both the manifestation of the Fed's successful effort to raise demand and the result of increased production and hiring. At some point, as the American economy approaches its potential output, the Fed may find it necessary to rein in inflation. For now, while a seemingly substantial output gap remains, higher inflation corresponds to faster recovery—and lower inflation to slower recovery. Rapid disinflation is no call for sighs of relief, in other words. It's reason for concern.

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