With the markets in turmoil, the risk of deflation is high

It was the further slide in oil prices that unnerved stock markets yesterday, pushing share prices down to the lowest they have been for two and a half years. But doesn’t paying less for petrol at the pump leave more money in consumers’ pockets? It surely works a bit like a reduction in VAT. And isn’t that a good thing? As is always the case with questions of economics, the answer is yes and no.

Listen to what a clutch of Nobel Prize winning economists were telling the Financial Times in Davos this week. Professor Kenneth Rogoff of Harvard said: “The third leg of the debt super-cycle does seem to be upon us.” Professor Michael Spence of the Stern School of Business at New York University added that we have “a fragile and deteriorating situation globally, with little in the way of effective counter-measures”. And Professor Bob Shiller of Yale University warned that the recent falls in financial markets had special significance. “There is more than the usual salience to this event and... a substantial risk of further such drops,” he said.

In other words, these famous economists don’t seem to be as impressed by the benign effects of a falling oil price as one might expect. The negative aspects seem to be uppermost in their minds. Why might this be? They may fear that a lower oil price is reflecting a decline in business activity around the world and thus signalling the likelihood of a recession. In favour of this point of view, one can point to weaknesses in economic activity and note that many industrial metals such as copper, iron ore and aluminium are also falling in price.

In the US, for instance, there was a drop in retail sales during December so that 2015 ended up as the worst year for shops since 2009. In the UK, weaknesses are developing in manufacturing and production. And then there is China. But the latest figures from China don’t show a collapse, only a slight loss of momentum. They are still very respectable. And given that the International Monetary Fund has just predicted that global growth, currently estimated at 3.1 per cent for 2015, will be 3.4 per cent in 2016 and 3.6 per cent in 2017, the overall outlook is far from alarming. As a result, even though the IMF warns that risks to the global outlook remain tilted to the downside, I don’t believe that weaker oil prices are pointing to a coming recession.

A better reason for concern is that lower oil prices could push leading economies into deflation. Just look at the latest inflation rates – calculated before oil fell below $30 a barrel. In the UK and France, inflation is running at an almost invisible 0.2 per cent per annum; Germany is at 0.3 per cent and the US at 0.5 per cent.

Almost certainly these annual rates will soon fall below zero and so, at the very least, we shall be experiencing ‘technical’ deflation. Technical deflation is a short period of gently falling prices that does no harm. The real thing works like a doomsday machine and engenders a downward spiral that is difficult to stop and brings about a 1930s style slump.

Referring to the risk of deflation, two American central bankers indicated their worries last week. James Bullard, the head of the St Louis Federal Reserve, said falling inflation expectations were “worrisome”, while Charles Evans of the Chicago Fed, said the situation was “troubling”.

There is a third reason for caution that harks back to the banking crisis of 2007 to 2010. At that time, overtrading by the banks in mortgage loans led to bank failures, and that in turn created recessionary conditions. This was because economies were starved of the financial facilities they need if they are to function efficiently.

So this time the question is whether the banks are over-extended to oil producers and other energy industry firms so that once again their imprudence brings about a recession. The issue is certainly a pressing one. Last Friday, the Wall Street Journal reported that months of low oil prices are starting to take a toll on banks. Large US banks reporting their profits to shareholders on the same day said they saw more energy loans go bad in the fourth quarter. Many lenders also added millions of dollars to reserves in anticipation that more oil-and-gas loans will sour. One chief executive was quoted as saying, “it’s starting to spread”. Credit issues from low energy prices are affecting “anybody who was in the game as the oil boom started”. Citigroup, which also reported on Friday, said it set aside about $250m in the period to cover energy-related losses.

Of these three threats, worrying as they all are, the most serious is the risk of deflation. This has been concerning governments for some time, hence the repeated bouts of what is called quantitative easing, a form of printing money. This tactic has had limited success. It has driven up asset prices without putting a floor under consumer prices. Moreover a prolonged period of deflation – when consumers continually postpone purchases in the belief that prices will soon be lower still – plays into the other fears described above. Producers of goods or suppliers of services are quickly weakened if they are faced with buyers’ delays. At the same time, fixed charges such as rent, interest on loans or repayment of loans, become steadily more onerous in real terms.

I don’t say that any of these things are bound to happen and I deplore the hysteria that has gripped the markets this week. But it is as well to be extremely vigilant. This is a time to have a Plan B. Or, more precisely, prepare oneself to take avoiding action.