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Despite stimulus measures, global economy faces risk of deflation

A market stall holder stands under bags with different prices on Oxford Street, London.

ANDREW WINNING/REUTERS

Inflation is retreating across the developed world, increasing the possibility that an extraordinary era of monetary policy will be extended as central banks struggle to hit their inflation targets.

A report Tuesday showed that consumer costs in Britain rose 2.2 per cent in October from a year earlier, a sharp deceleration from the September annual rate of 2.7 per cent. Swedish prices actually contracted last month from September, dropping the annual rate as measured by the central bank's preferred price gauge to 0.6 per cent from 0.9 per cent.

The figures were the latest reminder that global economic growth continues to disappoint. Unemployment is elevated and industrial capacity remains idle. Those conditions introduce slack into an economy and put downward pressure on prices.

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Weaker inflation raises the threat of price contractions, which, if they were to persist, could have a corrosive effect on any economy so afflicted. Both the Bank of England and the Riksbank in Sweden had forecast higher rates of inflation, increasing expectations that policy makers in London and Stockholm will pursue easier monetary policies to keep economic growth on track.

Most of the world's other major central banks are in the same position.

The European Central Bank last week cut its benchmark interest rate to a record low of 0.25 per cent after inflation in the euro zone slumped to 0.7 per cent, far from the ECB's price-stability target of roughly 2 per cent. In Japan, inflation is at zero, and in the United States, inflation is stagnant at a rate that is only a little more than half of the U.S. Federal Reserve's 2-per-cent target.

The phenomenon is making some people nervous. The cover of the latest issue of The Economist magazine, perhaps the most influential publication in global finance, depicts a deflating balloon descending into shark infested waters – imagery meant to highlight the danger of a deflationary spiral.

The anticipation of falling prices keeps consumers from buying, eroding business profits and sapping the incentive to hire and invest. Deflation also would make debt more onerous because it would become more expensive to finance relative to declining incomes.

"I'd like to see some movement toward the target" before tightening policy, Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said in an interview on Bloomberg Radio Tuesday. Mr. Lockhart said inflation is "stable but too low," that a faster rate would "give me some confidence we are not dealing with some downside scenario that might develop."

Despite five years of some of the most aggressive monetary policy in history, economic growth remains muted in the world's biggest economies, reflecting the depth of the financial crisis.

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Critics worry loudly that central banks have gone too far, insisting that ultralow interest rates will stoke out-of-control inflation. When Canadian Finance Minister Jim Flaherty last month lamented the Fed's policy of creating hundreds of billions of dollars to buy financial assets, he said his concern was rooted in images of Canadians leaving their homes in the 1980s because they couldn't afford the double-digit mortgage rates. Those rates soared because central banks were driven to snuff out inflation.

Yet nothing like that is at all close to happening. The greater risk appears to be the reverse. Canada's consumer price index was last growing at the Bank of Canada's 2-per-cent target rate in April, 2012. Increases have slowed steadily since, and annual inflation was only 1.1 per cent in September. The inflation path in the U.S. is similar.

"In principle, we should be worried," said Pierre Siklos, a senior fellow at the Waterloo, Ont.-based Centre for International Governance Innovation, where he studies monetary policy. "It's rather unexpected."

The degree to which one should worry is open to debate.

Carl Weinberg, chief economist at High Frequency Economics, a research firm based in Valhalla, N.Y., isn't that worried at all. He says for deflation to set in, wages must fall along with prices – and wages across developed economies are rising; modestly in some cases, but rising all the same.

In the U.S., average hourly earnings were 2.2 per cent higher last month from a year earlier. The consumer price index was 1.2 per cent higher on the year in September, suggesting wages are growing faster than prices, which could encourage consumption.

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To break a slide into deflation, central banks would have to shock the public into believing that they wanted more inflation.

John Makin, resident scholar at the American Enterprise Institute in Washington, said in a report last month that policy makers should reset their inflation targets if disinflation persists. He worries that central bankers, who have obsessed about keeping a lid on prices for two decades, aren't taking the risk of deflation seriously enough. "An obsession with inflation threats while approaching a period of deflation is a necessary condition for deflation to occur," he said.

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About the Author
Senior fellow at the Centre for International Governance Innovation

Kevin Carmichael is a senior fellow at the Centre for International Governance Innovation, based in Mumbai.Previously, he was Report on Business's correspondent in Washington. He has covered finance and economics for a decade, mostly as a reporter with Bloomberg News in Ottawa and Washington. A native of New Brunswick's Upper St. More

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