The dangers of deflation

The chief economist of the Bank of England, Andrew Haldane, has given the clearest signal a central banker can, to the effect that the bank rate will stay at 0.5 per cent well into next year.

Those, for example, on tracker mortgages linked to the bank rate will enjoy a further holiday from normal interest payments. By the end of next year they will have paid minimal interest on their home loans for about six years – quite a vacation. Savers, by contrast, and those looking for income in retirement will suffer some more.

As always, monetary policy, like anything else, has its winners and losers. For the economy as a whole, as Mr Haldane indicates, there is little alternative.

The threat of higher inflation as a result of the current spurt of economic growth, and the usual motive for a hike in rates, can be discounted (though shocks can never be ruled out). Oil prices have slipped back, and wages are enduring the longest squeeze in living memory, while sterling is enjoying some unfamiliar strength. Indeed, there is more danger of deflation than inflation, something we have not seen in the UK for the best part of a century and the pernicious effects of which are now posing a more serious threat to the eurozone, whose weakness remains a significant danger for the UK, as the Chancellor recently warned.

Deflation, and the ultra-low rates that accompany it, means consumers become even less willing to spend, and the real-terms value of debts goes up. Contrast that with the 1970s when rampant inflation shrank mortgages before borrowers’ eyes. Deflation has the opposite effect – making debt harder to service and pay off, and the effort to do so by households further reduces spending and weakens struggling economies. Japan has experienced something very like this for almost a quarter of a century.

For the dirty secret across much of the West is that a dose of old-fashioned, double-digit inflation would have dissolved much of the debt mountain, although with some unpleasant side effects. Despite the efforts of the central banks we have not seen such a demolition of debt.

Against such a weakening macro-economic background, the markets – spooked by Ebola and tensions in the Middle East and Russia – hardly needed an excuse to mark down prospects for growth, profits and share prices.

So rates must stay low so the economy can be supported, even as government and households continue the job of paying down the debts accumulated in the boom a decade ago.

A disappointingly large proportion of the billions pumped into the British economy seems to have been funnelled into things that have not stimulated the “real economy”: residential property, classic cars and, until recently, equities. Consumption and wages have not felt the benefit – and the recovery, though welcome and strong – has been a long time coming.

The long-term answer to the problems Mr Haldane’s speech highlighted lies beyond the control of central banks. Low productivity and skill levels, and lower wages, may have to be sorted by fundamental reforms. Looser labour markets, freed-up retail sectors, a more enlightened approach to foreigners investing and freer trade have all been on the agenda for years.

As the emerging problems in China’s property market and banking system remind us, the “global imbalances” – vast US debts funded by a vast Chinese trade surplus – are hardly better than they were in 2008. Until all these structural issues – large and small, national and international – are acted upon, the West will remain hinged between a sustainable long-term revival and another decade of near-stagnation. There will be more weeks like this past one.