ECB should adopt Fed's deflation concerns

Is there really a danger of deflation, a period when prices fall with damaging implications for economies? The Federal Reserve Board clearly thinks so, but the European Central Bank appears unconcerned, fretting about inflation like the Bundesbank on a bad day.

First, to the US, where the Fed warned this week that "the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pick-up in inflation from its already low level".

In the measured and elliptical language employed by central bankers, this is a strong statement, only qualified by the "though minor" clause. On balance, the Fed said it was still hopeful of an economic recovery "over time", but that over the next few quarters the upside and downside risks were broadly balanced.

Meanwhile, across the Atlantic in Frankfurt, the European Central Bank takes a different view of the world. The threat of deflation may be much greater in Germany than in the US, but the ECB left interest rates unchanged at yesterday's meeting.

Wim Duisenberg, the ECB president, said that the risks to economic growth had "waned" and that inflation would fall more slowly than expected. Against a background of German unemployment rising close to 11 per cent and a collapse in industrial orders in the euro-zone's largest economy, this statement suggests they are on the happy pills in the Euro tower and is in stark contrast to the Fed's approach.

Why should we be concerned about very low inflation rates and the threat of deflation? The reason is the risk of slipping into a period when prices are stalled or actually falling. This leads consumers to postpone purchases and businesses to do the same with investment. Why spend today when it might be cheaper tomorrow?

Deflation encourages savings, erodes investment and basically changes all the economic rules by which we are used to living. To use the current phrase, you don't want to go there. It also makes life very difficult for policy makers, as cutting interest rates no longer has the required stimulatory effect.

Keynes recognised this risk during the great depression, with his famous analogy that conducting monetary policy in such conditions - which he called a liquidity trap - was like pushing on a piece of string. Japan is in this kind of situation at the moment, although there has been academic dabte on whether it is a classical Keynesian liquidity trap.

A study by Fed economists* published in June 2002 found that, in hindsight, the Bank of Japan should have cut interest rates sooner and more quickly in the early 1990s and that this might well have headed off deflation. The key findings of the study were that deflation was difficult to predict and that when interest rates and inflation get close to zero, it is wise for a central bank to err on the side of stimulus, as the costs of a deflationary spiral are so large.

Japanese policy in the early 1990s was appropriate for the forecast performance of the economy, the study found, but given its actual performance the policy stance was too restrictive.

Perhaps the boys in Frankfurt might like to take a peek at the paper on the Fed's website. It shows clearly the dangers of pursuing an overly-strict inflation goal.

Mr Duisenberg did announce yesterday that this policy would now be tweaked with a goal of keeping inflation "close to 2 per cent" but then went on to say that the ECB would still define price stability as inflation of 2 per cent or less. On the one hand this appeared to show some flexibility from the current goal of getting inflation to 2 per cent or below and was set in the context of having an anti-deflationary tool. On the other, senior ECB executive Otmar Issing said there was no reason to expect a different monetary policy as a result. Confused? So am I.

The Fed study also found that Japanese fiscal policy in the key early 1990s periods was too restrictive, yet the latest missive we have from the EU Commission in Brussels is another call for cutbacks in the French budget, where the deficit is above the 3 per cent limit.

The great triumph of Irish economic policy, of course, is that with an inflation rate above 4 per cent we don't have to worry about any of this deflation nonsense. The Government's move to inflate the economy through spendthrift budgets and the recent hiking of indirect taxes and charges was, of course, a masterstroke to avoid the deflationary dragon now stalking the world.

The one teensey weensey problem is that the combination of slowly falling - but still high - Irish inflation and very low inflation elsewhere maintains the competitiveness squeeze on Irish industry.A rising euro intensifies the pressure further. Wholesale price figures from the Central Statistics Office this week showed that factory-gate prices for manufacturing were 7 per cent lower in March than a year earlier, due entirely to lower euro prices for firms selling into overseas markets.

Contemplate, for a moment, the task facing a company when the prices it receives are falling by 7 per cent while general prices in the economy in which it operates are rising by 4 per cent plus.

The transition to a lower inflation rate here may thus be at cost of a considerable number of jobs. Ironically, one of the few countries for which ECB interest rate policy may now be appropriate is Ireland. But, given the choice between the Fed and Frankfurt, I know which I'd choose.

*"Preventing Deflation: Lessons from Japan's experience in the 1990s." A June 2002 International Finance Discussion paper available on the Fed's website: www.federalreserve.gov