Jeremy Warner: In attacking deflation are we not just stoking inflation?

Outlook To believe the noise, we are already in a 1930s-style deflation. Yet inflation figures announced yesterday show that we are not there quite yet. To the contrary, consumer price inflation (CPI) was still a way above target 3 per cent last month, while even the retail prices index (RPI), which takes account of plummeting mortgage and housing costs, is still above zero, albeit only marginally.

Both these numbers are widely expected to fall further before they bottom out, but, on the CPI measure at least, it is by no means certain we are about to enter a period of outright deflation, and on a longer-term perspective the jury is still very much out on which is the bigger threat. Is it a deflationary or inflationary world we are heading into?

Public policy in America is firmly focused on the former danger. In Europe, the response has been more ambivalent. In a speech to the European Parliament this week, Jean-Claude Trichet, president of the European Central Bank, seemed keener to emphasise the dangers of the monetary and fiscal response than their palliative powers. In addressing the present crisis, he warned, we risk stoking an even bigger one for the future.

These differences show we are all creatures of our own histories. The Americans look back to experience of the Great Depression and think no price too big if it means avoiding a repeat of that deflationary calamity. On the Continent, monetary policy still seems to take its cue from the hyper-inflation of pre-war Germany, which destroyed the savings of an entire generation and sowed the seeds for the rise of fascism and World War II.

Both points of view are equally valid. Economically, we are in virgin territory. A return of inflationary pressures might seem the least of our worries right now, but it is by no means impossible that in two to three years we’ll again be trying to put the inflationary genie back in its bottle. In fighting the deflationary threat, we seem to be making every effort to lure him out, with unprecedented infusions of public money to keep economies afloat.

As I say, in a few years, all this policy action may be judged to have worked only too well. It’s far too early to start talking green shoots, but there are already one or two signs of confidence returning, with anecdotal evidence pointing to a marked recovery in housing-market transactions. There is indeed a perfectly reasonable line of argument to suggest economies need periods of deflation, at least in asset prices, to rebase prices in line with the more limited demand and supply of money that comes after the excesses of a boom. Interfering with this process only delays the recovery, or worse, stokes another bout of credit-fuelled inflation.

That said, deflation must regrettably remain the primary concern, at least for the time being. As Mervyn King, Governor of the Bank of England, remarked at his quarterly press conference last week, the deflationary threat paradoxically requires him to fight the disease with the exact opposite of what he thinks appropriate for the medium term. Once deflation gets a grip, it’s very hard to get rid of, as Japan has proved over nearly 20 years.

Deflationary conditions cause three main difficulties. One is that they inflate the real value of outstanding debts. For a nation of debtors, such as Britain, this is extremely dangerous, in that the only way of clearing the debt would be through mass bankruptcies, leading to a domino effect of multiple defaults and rising unemployment. Even in a deflationary environment, companies find it very difficult to reduce wages, so instead they tend to deal with declining demand and prices by making workers redundant. And finally, when prices are falling, households give up consuming and start saving, leading to a further collapse in demand. Why buy today if you expect prices to be cheaper tomorrow?

Yet fighting the deflationary dragon is like playing with fire. If you try to devalue and reflate your way out of deflation, as Britain is trying to do at the moment, you risk both the return of inflation and the possibility you might eventually bankrupt the country. Amid all this confusion, one thing does seem certain. Confidence in the ability of central bankers to meet their mandates – in Britain an inflation target of 2 per cent as measured by the CPI – has gone up in smoke.

During “the great moderation”, the Bank of England achieved some success in anchoring inflationary expectations around this number. You could rely on inflation being around 2 per cent, because the Bank through clever use of interest rates would ensure that’s where it would remain.

This certainty now seems to have been more down to a benign economic environment than policy prowess, but, in any case, it has now gone, destroyed by a heady cocktail of soaring oil prices and credit-crunched banking dislocation. The Bank of England has proved incapable of holding to the line, slipping down precipitously on either side. Since last September, we have veered violently from 5 per cent inflation down to nought, with every prospect of prices shortly turning negative. Not for nothing are central bankers accused of losing the plot.