A long, slow slump: will Britain go the way of Japan?

Latest figures show that prices in the UK are falling at the fastest rate for 20 years. It's good news that essentials such as petrol and food are getting cheaper, but there's a dark side to falling prices, says John Stepek. We could soon be in serious danger of a Japan-style deflationary slump.

By John Stepek

published 19 November 2008

in Features

For once, pensioners got lucky this year.

State pension payments (and many state benefits) are uprated each year in line with the Retail Price Index measure of annual inflation. The relevant reading is taken in September. In September, RPI inflation came in at 5%, its high for the year.

Just one month later, in October, pensioners would have been looking at a rise of just 4.2%, as RPI inflation fell sharply. And with further falls ahead, that 5% rise will look pretty tasty.

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Of course, it's not all good news. Because as interest rates fall, so will savings rates. The state gives with one hand, and takes away with the other

Inflation will keep falling

British prices last month fell at their fastest rate since comparable records began 20 years ago. The annual rate of consumer price index inflation (CPI the bank's target measure) fell to 4.5%, from 5.2% in September. It's still well ahead of the 2% target, and far above the 3% level, above which the Bank of England has to write a letter to the Treasury.

But it won't be there for long. The plunge was driven mainly by steep falls in food and petrol prices. That's what you'd expect, given the collapse in oil prices and tumbling agricultural commodity prices too.

With oil prices showing little sign of recovering and every sign that they could fall further - the slide is likely to continue in the coming months. In fact, Jonathan Loynes at Capital Economics reckons that "not only is inflation in the UK still dead, but deflation is about to be reborn."

Loynes reckons that CPI will turn "briefly negative in about a year's time". RPI inflation could even go as low as -2% (pensioners need not worry unduly the government guarantees a minimum 2.5% annual uplift, though we'll see how keen they are to do that in a year's time).

Loynes points out that this could have "positive effects on the economy by boosting spending power." But of course, in a year's time people will almost certainly still be in "cut-back" mode. Job losses will be high and rising, house prices will still be falling, GDP will be falling so any money "saved" through falling prices is likely to be spent on paying down debt rather than buying more goods.

Deflation is now the big worry

And of course, because it's been driven largely by commodity prices, inflation isn't just falling in the UK. It's diving in the US as well. Producer price inflation prices at the factory gate, basically fell at a record rate, down 2.8% in October. The annual PPI inflation rate came in at 5.2%.

So deflation is now the big worry. Investors unsurprisingly expect further interest rate cuts in the UK two-year gilt yields hit a record low yesterday, falling below 2% for the first time since records began 30 years ago. And in the US, markets moved to price in a further 0.5 percentage point cut in the Fed funds rate in December. That would leave US interest rates at just 0.5%.

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The big question is whether the West can see off a big Japan-style deflationary slump, or whether we'll be stuck with what the Japanese have been suffering for nigh-on two decades, for the foreseeable future.

Nomura economist Richard Koo has written a couple of books on Japan's problems. His take, in "The Holy Grail of Macroeconomics" is that companies reached a point where they simply didn't want to borrow money. Their key goal became to pay down debt he calls this a "balance sheet recession."

If companies and consumers are focusing on paying down debt, he argues, then the state has to step in and spend for them. And that's what Japan did. In fact, Koo argues that the economy there would have been in an even worse state if the government hadn't stepped up spending as it did.

That's a worrying thought. The good news is that he doesn't think that the US will suffer the same sort of 15-year stagnation as Japan has, simply because it's got Japan to learn from. "Now that we have much better knowledge of the way the balance sheet recession operates, the US has no reason to make the same mistake made in Japan."

We've more on Koo's thesis in the next issue of MoneyWeek (out on Friday - subscribe to MoneyWeek magazine), but certainly, the psychology rings true. However, the idea that the government has to keep pumping money into the economy until it recovers is a worrying one.

The Fed is trying to prevent a repeat of Japan

As the team at Societe Generale point out in one of their most recent research notes, the Fed is certainly doing its best to prevent a repeat of Japan. It is expanding its balance sheet and lending directly to businesses. Indeed, Soc Gen reckons that "sustained deflation is unlikely with such massive increases in the monetary base. In fact, if the massive cash injections are not reversed quickly once credit markets recover, the Fed's [actions] could set off another wave of serious inflationary pressures in 2010-2011."

We'll have more on this in future Money Mornings. For now certainly, deflation lies in the immediate future. But beyond that the outlook is much less clear. That's one reason why we'd be holding onto gold for now with concerns over the stability of the financial system still high, and rampant inflation still a definite future possibility, it's one of the best insurance policies to hold. My colleague Dominic Frisby has more on the current state of the physical gold market look for his story on this site later today.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.