Not yet true that deflation has become endemic

ANALYSIS:A sharp rate of deflation should encourage wage cuts, which are not yet the order of the day, writes JIM O'LEARY

THE ANNUAL inflation rate plumbed new depths in May, reaching minus 4.7 per cent in the month. This represents the biggest fall in the consumer price index (CPI) since 1933, an appropriate historical benchmark given that the economy is experiencing its sharpest downturn since the Great Depression.

On a monthly basis, the CPI fell by 0.5 per cent, making May the seventh of the last eight months in which the price level fell, and taking the cumulative decline since last September to 5.5 per cent.

Much of this decline has been due to falling mortgage costs and so, abstracting from this factor, the pace of deflation is a good deal slower. The so-called Harmonised Index of Consumer Prices (HICP), designed to permit like-for-like comparisons across the member states of the EU, which differs from the CPI principally because it excludes mortgages, has fallen by 2 per cent since the September peak and by 1.7 per cent since May of last year. Much of this decline in turn is due to falling prices of energy products, not only oil but electricity and gas.

By far the greater part of the drop in the CPI (a proportion estimated by the CSO at 94 per cent on either a three-month or a 12-month horizon) is directly attributable to mortgage costs and energy prices. It is not (yet) true therefore that deflation has become endemic, much less that it has become a universal phenomenon. Yes, goods prices generally are dropping (prime examples being food, clothing and footwear, and household durables), but most categories of services, and especially publicly provided services, continue to see prices increases, albeit at a slower pace than hitherto.

With interest rates now close to their trough and oil prices already past theirs, the questions of whether and at what pace the overall price level continues to subside depend on whether and to what degree downward pressure on prices spreads out from the housing and energy sectors. Already it seems that deflation forecasts for this year will be exceeded. Until recently, the average expectation among forecasters was that the annual average fall in the CPI this year would be 4 per cent. Even if the index remained unchanged at its May level over the balance of the year, that would be achieved. In the more likely event that the index falls further, the average rate of deflation for the year will be greater than 4 per cent and could be 4.5 per cent or more. The annual rate will top 5 per cent in June/July and will probably top 6 per cent by the autumn.

Consumers are the big beneficiaries from this.

On the other side, government is a big loser since a high proportion of its spending commitments for 2009 was undertaken in the expectation of a positive inflation rate and a significant proportion of its revenue (eg VAT) is influenced by prices.

From the point of view of the overall economy, deflation is a positive to the extent that it reflects falling production costs (eg energy prices) or anticipates future cuts in production costs by facilitating a reduction in wages and salaries here relative to our main trading partners. In this connection, two sets of observations are worth making.

The first relates to the latest available official information on labour costs. This suggests that, despite the anecdotal evidence, wage cuts had not become the order of the day, at least not by the final quarter of last year (the latest period for which data have been published). The CSO’s preliminary estimates for Q4, published on Tuesday, showed average hourly earnings rising at an underlying annual rate of 4.5 per cent across industry and the financial sector. Granted, it was only towards the end of the quarter that it became clear that the annual inflation rate was decelerating sharply towards negative territory. It is likely therefore, that the Q1 data (when they’re published in three months’ time) will indicate a corresponding change in wage behaviour.

The second observation relates to what’s happening on the inflation front in our European trading partners. Yesterday’s CPI release from the CSO contains the relevant HICP numbers for April. For that month the annual HICP rate recorded for Ireland was - 0.7 per cent; the average for the euro zone was 0.6 per cent. So, our price level is falling relative to the euro area as a whole (good news), though at a slow enough pace (which qualifies the good news somewhat). Most of the rest of Europe is essentially experiencing zero inflation so, for us to make competitiveness gains in the short run requires us to deflate at a sharpish rate.