Deflation: An abject failure in the BOE's monetary policy

Author: Mike Paterson | Category: Education

More from our guest economist John Hearn

Deflation: An abject failure in the BOE's monetary policy

I tell my students that when inflation rises above 10% then people really begin to notice and start to change their spending habits. In the past double rather than a single digit attracted a lot more media attention and the effect of people bringing forward purchases increased the velocity of circulation of money. In turn this increased monetary demand and pushed up the rate of inflation even higher.

However if we move the decimal point two places to the left then 0.1% deflation tends to have a similar, though opposite, effect on peoples spending habits as they start to hold back purchases. This slows down the velocity of circulation of money as there is no rush to buy when prices are falling and the value of money is rising. Should this deflation become entrenched then even expansions in the money supply may not offset the contraction in monetary demand due to a slowing velocity.

As we have currently recorded a 0.1% rate of deflation it is time to look at why and whether there will be any long term damaging effect.

Over many years of observing the Bank of England I have always been a little annoyed by the prevailing attitude that when things are going well, it is because of the wonderful policies of the Bank of England and when things are going badly it is in spite of the wonderful policies of the Bank of England. In other words the Bank always seems to get away with avoiding taking responsibility for problems that it has caused.

So let us look at the problems of inflation and, more particularly, deflation. Firstly I remind you that the Bank of England has a target for inflation of 2% and deviations from that number of +/- 1% are considered to be a policy failure that requires an open letter to the Treasury. The impact and relevance of this letter has been downgraded quite effectively by not requiring it to be written and published directly after the event is reported.

Until recently the Bank has been missing its target on the upside, above 3%, but in the last few months it has missed target on the downside, below 1%, and this month it has dipped into deflation. Each time it has missed its target it has misled people by implying that particular costs and prices have caused the deviation. However this requires an acceptance of cost push inflation/deflation and is usually explained by rises or falls in prices such as energy prices and food prices.

Cost push inflation is a fallacy as can easily be seen by reflecting on the fact that inflation is, by measure and definition, more units of money used in the same number of transactions, while deflation is less units of money used in the same number of transactions. The critical point is more or less units of money and it is the Bank of England that controls the number of monetary units in the economy. As the Bank has total responsibility for the money supply and monetary demand so it is the sole cause of all deflations and inflations in the currency of the economy.

The problem here is that it misleads us by suggesting that changes in costs and individual prices are the cause of its failure to achieve target. On 19th May 2015 the Bank brought out its chief spin doctor Mark Carney to support this deception by saying that deflation was the result of falling energy and food prices, which is a cost push myth, and then added that the Bank is going to bring inflation back to its 2% target, which is probably correct. So the Bank has admitted that it can achieve a set target, while excusing itself from achieving the current target by evoking the cost push myth and blaming a fall in energy and food prices. Now for this not to be a contradiction the Bank should be able to set individual prices, in this case food and energy, and we know it cannot do that.

I was discussing this very point in the pub last night with a very intelligent friend who we can refer to as Mr Smith. He said he was confused by the terms negative inflation and deflation. I explained that they are the same thing and the first term is often used to disguise deflation. He said that this was wrong as he had looked up the definitions and negative inflation is just a downward blip in the average level of prices, while deflation is a more persistent fall in the average level of prices. I explained that this is just an attempt to deflect attention away from deflation and went on to say that every time the average level of prices falls that is deflation and every time it rises that is inflation.

The Bank of England has therefore missed its target and more damagingly it has caused the economy to dip into deflation. Rather than admit its mistake and promise to rectify the problem its own spin machine has gone a stage further by suggesting that not only is it not the Bank`s fault but that deflation is actually good for the economy as it means lower prices and an increase in real wages and that we should make the most of these good times. Exactly the same was said after World War One when the UK economy dipped into a deflation that ruined many peoples livelihood throughout 1920`s.

Of course a fall in some prices is good for the economy as it benefits some and helps reallocate resources more efficiently. However this should not be confused with a fall in the average level of prices which is likely to be damaging to the economy as the UK, USA and Japan have found, to their cost, in the past.

So let us have the truth from the Bank of England. They have mismanaged monetary policy and caused what could be the start of a damaging deflationary period. However I do not think that this is any more than a deflationary blip as Mark Carney said we know how to increase the rate of inflation to its 2% target and they can do it without any help from individual prices and costs.

John Hearn 20/5/2015

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