Hamish McRae: Falling prices may yet prove the real danger for central banks

Deflation or inflation – could the central bank guns be facing in the wrong direction?

The Bank of England's position yesterday seems still to be that the greater danger is inflation and there are several reasons to support that view. The US Federal Reserve has evidently made the opposite judgement. The European Central Bank seems still to be in anti-inflation mode despite the evidence of the reverse in Germany. And in Japan, well, the only issue is how to extract the country from deflation, rather than how to avoid it.

So the short answer to the question above is that it depends where you look. Deflation does not yet seem to be a contagious disease for, with the possible exception of Germany, it has not yet spread from Japan to the rest of the world. But the Fed is seriously worried that it might and determined to avert the danger, while we are not. Could the Fed be right and the Bank (and the ECB) be wrong? Or, put another way, is the US more likely to slip into deflation than the UK?

The starting point must surely be the parallels between the US and UK. Both economies have serious imbalances, though in somewhat different proportions. Thus the US has a current account balance that is double that of the UK as a percentage of GDP, a bit over 4 per cent against a bit over 2 per cent. In both countries consumers are spending above their income, with US household savings even lower than British. Both have experienced a housing boom and this has helped support consumption.

This last point is in contrast to all the other major economies: the left-hand graph shows how our boom has outstripped even the US, while prices elsewhere have either slumped, or as in the case of France and Italy, struggled to regain ground lost in the early 1990s. So in the sense that housing inflation is a problem, we have it to a greater extent than anywhere else. You can see very obviously why the Bank is concerned. Even if house prices are not part of the retail price index (which measures the price of the flow of goods and services, not the price of assets) any central bank has to be worried about the potential instability a housing bubble causes.

Meanwhile UK inflation has another odd feature. It is almost in round numbers, the price of goods is either stable or falling while the price of services is rising by close to 4 per cent a year. Moreover the gap has widened. You would expect some sort of gap, partly because the price of raw materials has remained very low but more because it has long proved easier to get increases in productivity in manufacturing than in services. But you would not necessarily expect the gap to widen. The second graph shows how it has risen from an average of about 2 per cent in the late 1980s and early 1990s to more than 4 per cent now.

It is bound at some stage to fall back but we don't know whether this will be because of a rise in the price of goods or a fall in service inflation. Should sterling weaken that would increase the cost of imported raw materials and imported finished goods, both of which have been weak in recent years. The general view is that sterling is too strong so some decline would be likely. I don't happen to agree with that as I think the UK economy is managing remarkably well at the present rate – but it would be silly not to acknowledge the risk of a fall in the pound. So there is some danger of imported inflation, following a decline in the currency.

Is there also a danger of a collapse in consumption as the housing bubble deflates? There are two views on this.

One is that once people realise that the housing boom is over, prices could fall quite fast, particularly in the present hot spots. People have extracted value from their homes by borrowing against them and spent it on themselves. You can see this gap between the growth of GDP and the growth of consumer spending in the third graph.

The other is that a slump in consumer spending is not that likely. Goldman Sachs argued in a recent paper that more than half of this lift in consumption could be explained by the improvement in the terms of trade this country has enjoyed over the past seven years. This expression means the ratio between the price of our imports and of our exports. Imports have become relatively cheaper while our exports have become relatively more expensive.

So consumer spending in real terms has indeed risen faster than GDP, as you can see. But if you do the same calculation in nominal terms – actual pounds – the gap has not been so big. The final graph shows this.

What should you conclude from this? Goldman takes the view that this decreases the danger of a sudden correction in consumer spending and that must be right providing – a big proviso – that the pound remains strong.

One worry from the Bank's point of view must be that this relatively benign state of affairs could go into reverse. There could be a sudden weakening of sterling, maybe a rise in commodity prices, plus an end to the housing bubble. All this could lead to a sharp fall in consumption and there would not really be any weapons it could deploy to counteract this.

We will see. The good news is that the UK authorities have some firepower. The fiscal guns have already been fired, with the current huge increase in public spending. But we have scope to fire the monetary weapon and cut interest rates.

The US has fired both fiscal and monetary guns, with the tax cut and the increase in Federal spending, coupled last week with the cut in interest rates. Once you are down to 1.25 per cent there really is nothing left: further cuts merely suggest panic, as the Japanese have learnt. The balance of probability is that the US authorities will indeed beat off the danger of deflation but the balance is fine.

Europe's guns are spiked. Countries cannot increase their fiscal deficits – or rather they are limited in the extent to which they can do so overtly, for the stability and growth pact is still notionally in place. At any rate the countries that need a fiscal boost cannot do so, though those that don't could. And the countries that need to cut interest rates cannot do so because that power is ceded to the ECB, which has to balance their needs against those of the rest of the eurozone.

So the problem is not that the guns are facing in the wrong direction. Rather it is that the US has no ammunition if the danger is deflation – though it has plenty if inflation returns. The ECB has to wait until it knows whether deflation will get out of hand in Germany, in which case it will either have to take risks with inflation elsewhere or condemn core Europe to a slump.

And us? The Bank is right to worry about inflation, even though it has pretty consistently undershot its target. Indeed it is right to worry precisely because it has undershot in the past: the reasons for that undershooting could now go into reverse. But globally we may be the somewhat lucky exception: a haven of (slight) inflation in a deflating world. But not inflation of house prices. That game will soon be over, as common sense suggests.