Tuesday, January 27, 2009

TUESDAY COLUMN:Worried about inflation? Prepare for something worse

Expect what would have once been joyous news tomorrow.

Australia's inflation rate will be low - so low that for the December quarter it will have turned negative.

That has to be good, right? Falling prices will make our money go further, and then further. Added to dramatically lower interest rates and the gift of an extra $1,000 or so that many of us received from the government in December, deflation will help push our buying power higher than its been in years.

And we know that high inflation is bad for the economy - the Treasurer Wayne Swan used to continually say so - so low inflation leading to deflation has to be good for the nation, right? Wrong. Prepare to unlearn much of what you've learned.

For decades now we've only been told half of the truth about inflation...

- that a high rate of price rises devalues money, destroys the value of savings and makes it hard to plan. Let unchecked high inflation is likely to accelerate as buyers bring forward their buying decisions to get in ahead of price rises, encouraging sellers to push prices higher still. We haven't been told the other half of the truth because, well, when was the last time that prices sustainably fell?

They did it during the great depression. And the further they fell the worse the depression became. Deflation is worse than inflation. And the Reserve Bank knows it. That's why its inflation target is clearly in positive territory. Instead of adopting a target of, say, between minus 2 per cent and plus 2 per cent, which it might have done if it believed the likely damage from deflation more or less matched the likely damage from inflation, it has picked a target well away from negative territory and even well away from zero. Its target of 2 to 3 per cent is an acknowledgment that while too much inflation can be bad, any deflation can be worse.

Much of the deflation we will learn about tomorrow will be the result of a one-off slide in petrol prices and so needn't be that concerning. It shouldn't become self-perpetuating. But there is a chance that it could.

The Melbourne Institute reported last week that an impressive 9.8 per cent of us expect inflation to be negative throughout the year ahead - the biggest proportion since it began asking the question.

If these people act on that belief they'll put off non-essential purchases. "Sure, now's a very good time to buy something," they'll tell themselves, "but in six months time it will be even cheaper".

Retailers will find themselves cutting prices upfront to bring forward those sales, inadvertently reinforcing the belief that prices will fall further if only consumers hold off, encouraging consumers to hold off longer and pushing prices down further in a self-reinforcing spiral.

There are signs that retailers are already discounting savagely. The wholesale prices that they pay for imports soared an extraordinary 10.8 per cent in the final three months of last year as the Australian dollar slid. Over the year their total import costs soared 22 per cent, the cost of their imported office equipment soared 30 per cent, and the cost of imported cars soared 8 per cent. Yet the prices they charged for those things have scarcely moved. If anything cars and computers are on sale. And most of us aren't buying, yet. Why would we?

Rather than keep cutting prices, retailer Gerry Harvey has begun shutting stores. Others will follow if deflation takes hold, and the resulting unemployment will make even the majority of us who keep our jobs still more wary about buying, pushing prices down further and pushing more of us out of work.

It's a far from unlikely scenario. Japan suffered from deflation for more than a decade from the start of the 1990's. The more prices fell the more consumers shut their wallets and the more factories wound back their operations. Deflation is now a serious concern in Britain, in the United States, and in Japan again.

If it gets a hold here it may make monetary policy as ineffective as it has been there. Lower interest rates won't encourage spending if Australians expect prices to fall and they won't do much to encourage borrowing either. Why borrow to buy something that's going to decline in value? It's logic that applies to borrowing to buy a house if real estate prices are falling and to borrowing to buy (or expand) a business if the income from that business is set to fall. In Japan even interest rates close to zero couldn't expand borrowing.

Australia may well escape sustained deflation. The occasional quarter of negative inflation is not that unusual. Our last was in December 2006, also the result of a fall in the price of petrol. We had better hope that this one doesn't turn into something more.

If it does, our leaders might find themselves powerless to turn it back. That's why its imperative to prevent deflation before it takes hold. So concerned is the Prime Minister that he has asked the Treasurer to hitch a ride with him to Papua New Guinea today so they can keep talking about what action to take right now.