Disinflationary forces are welcome to many and should not automatically be feared

One of the features of the world economy right now is the fall in commodity and oil prices. This is something which has been developing since May in commodity markets although the overall peak in commodity prices was back in April 2011 when the Commodity Research Bureau index topped out just over 580. The pattern for the oil price is very similar with the peak of 2011 being followed by a drift lower which has become a sustained fall since late June. There are a lot of implications from this but I wish to state at the outset that the media headlines which scream deflation in response to this are as much “inflation-nutters” in my view as those who continually predict hyper-inflation. We live in a world where the chances of both remain low even though they both have risen. But the deflationistas have blinkers on as they repeat the phrase “there is no alternative” and sing along to the lyrics from REM that I quoted yesterday.

It’s the end of the world as we know it
It’s the end of the world as we know it

What is deflation?

It is a fall in aggregate demand in an economy. In its worse case it is associated with falling prices or outright disinflation and also falling wages as everything hits a downwards spiral. This can happen as the Euro area has demonstrated with its policy disaster that is Greece and there are plainly deflationary issues for Italy and France. But it can also happen without falling prices,they do not have to come together. After all I discussed a case only yesterday in Russia where there is deflationary pressure from higher interest-rates and a lower oil price plus plenty of inflation.

What is reflation?

This is simply an increase in aggregate demand and many countries are seeing this right now as lower oil and commodity prices means that for a given income they have more to spend on other things. Also as lower prices lead to lower inflation – even the UK only has an official consumer inflation rate of 1.2% now – then some of the pressure on real wages will be relieved. These sort of effects can be very powerful.

Unfortunately the economic literature (econometrics) on this subject has mostly confused itself. A fundamental problem happens measuring anything in economics because nothing happens in isolation. But whilst improved energy efficiency means that oil price effects are not what they were in the 1970s they have picked up since the middle of the last decade. And yes if you do read the literature it told you that the impact had pretty much disappeared just as it returned!Oh well. So I remain of the view it is quite a powerful mechanism but cannot outright prove it. Also the credit crunch has raised the impact of it as we observe yet another impact of it. For the UK this shift is added to be the fact that we moved from being an oil exporter to an importer over the same period.

There are also shifts of income and wealth

Changes in oil and commodity prices have a redistributive effect. Perhaps the simplest to think of is the gains to the Middle East from oil price rises and right now they way that many there must be grinding their teeth as it falls. Also there is the case of the South China Territories ( Australia and in particular western Australia) which boomed on the back of supplying ever more commodities to China at ever higher prices. Well until recently anyway.

On the other side of the coin commodity buyers experience relative drains on their income and wealth to buy these goods but right now are gaining as prices fall and their money goes further.

Right now there are issues with this for my subject of yesterday Russia which is seeing shifts of both income and wealth away from it especially for the period which the oil price has been below its estimated cost of production of US $90 per barrel. Many will be wondering if the game of realpolitik is at play here.

The oil price

The price of a barrel of Brent Crude Oil has fallen another 2% to US $83 today after Saudi Arabia cut prices to the United States. This means that a fall of 6% in July was followed by a fall of 2% in August, 8% in September and 12% in October. Putting it another way it has fallen by 22% on a year ago. So this is a better phase for the Harvard Energy Survey I reviewed back on the 20th of July 2012.

Contrary to what most people believe, oil supply capacity is growing worldwide at such an unprecedented level that it might outpace consumption. This could lead to a glut of overproduction and a steep dip in oil prices.

It took a couple of years but maybe at least for now they are being proved right. Of course “peak oil” will have better days than these but for now whilst there are also redistributive effects this is good for the world economy.

One impact will be on users of fuel as for example diesel prices at the pump in the UK are 9 pence per litre cheaper than a year ago and petrol prices are 6 pence lower. As a diesel driver may I welcome the split! Also @MarcoMNYC  pointed this out on twitter earlier.

based on 2013 gasoline consumption..a move from 3.5 to 2.75 a gallon gives back 100.87 Bn USD.

Commodity prices

The headliner in this area has been the price of iron ore which due to the slow down in China has been falling in 2014. According to Bloomberg the beat goes on.

Ore with 62 percent content delivered to Qingdao fell 1.2 percent to $78.63 a dry metric ton yesterday, the lowest since Sept. 30, according to Metal Bulletin Ltd.

Iron ore in Qingdao tracked by Metal Bulletin is 42 percent lower this year.

If we move onto more general commodity prices then it thinks this.

That’s a steeper decline than posted by the Bloomberg Commodities Index (BCOM) of 22 raw materials from gold to crude oil, which dropped 7 percent in 2014.

Actually I think that Bloomberg has missed a trick with its own index as the fall since the beginning of May or the new disinflationary phase has been just under 16%.

Oh and whilst overall prices are lower not all are. Food prices rallied by so much before the disinflationary phase started that they are still 8% higher on the year.

What about Japan and Abenomics?

Here we have a “Houston we have a problem” moment. Japan is using a currency depreciation to stoke inflation and to supposedly thereby reflate as well as inflate its economy. However right now its industries would be benefiting from lower import costs as their competitors are. But Abenomics is denying them some of the gains which in price-competitive industries might be fatal.

Comment

There is much to consider from the current phase of lower commodity and oil prices. Whilst they may be a response to the economic disappointments of 2014 we should not ignore the fact that they offer gains in 2015 and 2016 should they be sustained. A Type of self-correcting mechanism if you like or it will be if policy-makers do not interfere. Such a theme provokes a wry smile on a day where the European Commission has cut the economic growth forecasts for Europe. Timing is not their forte. But my rebuttal to the deflation mania infecting the media is that falls in inflation can be welcome and are welcomed by many who are hard-pressed in these times. Just as they panic a self-correcting mechanism looks to be in play.

However not everyone benefits as there are losers such as oil producers and commodity producers. I mentioned earlier that the oil producers of the Middle East and commodity miners in Australia will be losers as I guess will Canada. But for much of the world it will be welcome. Can it go on forever? Well maybe not as I guess more and more oil production is becoming uneconomic especially the frackers. If I did not already think this the regular denials would do the job!

Meanwhile in the background it would appear that there are genuine advances in photo-voltaic or solar power such that it is not inconceivable it will match conventional energy costs. Good job the UK paid so much for its new nuclear power station…….

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19 thoughts on “Disinflationary forces are welcome to many and should not automatically be feared

  1. Never mind welcome, disinflation would be a godsend to many millions in this country alone; but they are the lower stratae of society, so who cares?

    • Hi therrawbuzzin

      I do for one. However I agree with you that the establishment is more concerned with equity prices and house prices. Oh and bond yields low enough to make the debt they have accumulated look viable.

  2. Hello Shaun ,

    So we really are in a alternate universe – mirror mirror – Star Trek

    dis-inflation should be the default for a fully functional capitalist system? Cheaper goods and services for all , rich or poor , after all its not only the poor that feel the benefits the rich get richer too!

    But for some reason only Alice through the looking glass could understand is we need to be poorer ? well those that don’t count ofcourse…….

    The answer appears to be debt , that it can’t be paid down or gets bigger but this is plainly false as we don’t spend so much on the goods we need then we can pay back the debt?

    Hah! I forgot the Banks need us to take on more debt so we can more of slave to them and to justify their excessive pay packets .

    The ” master of the universe” cannot rule when we a free of debt ( to them atleast )

    Forbin

    • Hi Forbin

      I remember the episode which they repeated in terms of theme in the prequel Enterprise series. As to disinflation I agree that at times it is a function of a thriving system. Also there seemed to be a shortage of complaints as all sorts of technology saw heavy disinflation if you measure it by output to price. I do not recall too much evidence of people waiting and waiting to buy for a lower price do you?

      It is why they wanted to target nominal GDP growth as real growth plus inflation is a measure which reduces debt burdens.

      Speaking of disinflation I note that at Tesco’s one can now buy 3 packs of popcorn for £2.50. That should keep you going for a bit…

  3. Great column, Shaun.

    Canadian growth would be adversely affected by low oil prices:

    http://www.huffingtonpost.ca/2014/10/30/oil-prices-canada-economy-poloz_n_6071118.html

    As the link indicates, Governor Poloz of the Bank of Canada told the Senate Banking Committee that a continued low oil price would cut real GDP growth for 2015 by one quarter of a percent. However the junior Finance minister said that even if oil prices stayed low it would not imperil the federal budget getting back to surplus.

    By the way, from the news accounts, no-one in the Senate Banking Committee seemed to be curious as to why the July Monetary Policy Report of the Bank of Canada forecast the core inflation rate staying below the 2% target until 2016Q3. The core inflation rate for 2014Q3 was 2.0%. If I were on that committee, I would certainly be curious why the central bank had done such a poor job of forecasting inflation, and wonder how much faith could be put in their forecasts of low inflation rates going forward.

    • Hi Andrew and thanks for the link.

      If we take the impact of falling commodities prices on Canada I would expect its impact to be more than 0.25% of GDP but some that what depends on where they settle.

      As to the forecasting issue that is true of most of the central banks I look at. I guess Sweden in its reverse-course and 0% interest-rates has been the most wrong-footed but the ECB has embarrassed itself too. For once the Bank of England has been wrong as usual but fewer people care as these have been favourable errors (solid growth with low inflation). However the irony is that this shabby crew thinks it can offer “Forward Guidance” ! At least the Bank of Canada is stepping back from that.

  4. Fracking has a $60-$80 production cost range, so I guess the market will be self correcting fairly quickly, with the short well life and the slowing down of the drilling of new wells. Many of the fracking companies are financed by Junk Bonds, whose prices have been dropping, so the interest rates are now 15-16% which is going to affect the rolling over of debt and new borrowing, so with this, along with evaporating profit margins, what could possibly go wrong?

    When its dark and the wind is not blowing, you will be glad of the nuclear backup. I was recently reading about the solar panel advances where they can get expensive gold based satellite panel efficiency at much cheaper prices through using different materials, but where all solar panels are very energy intensive to manufacture, the EROEI ratio is quite low. I recently read a very interesting report by the Adam Smith Institute on real world wind farm performance and it does not make pleasant reading with the windmills working at 90% of peak power only 17 days a year and at under 20% for 23 weeks of the year in the UK, Europe is even worse! The report can be found here: http://www.adamsmith.org/wp-content/uploads/2014/10/Assessment7.pdf

    Where all the advanced economies are dependent on the oil price, the dropping prices will hopefully be good news for growth and wage rises, unless you live in Russia and produce oil at $90bl. Saudi Arabia have stated they are happy with around $80bl for at least 12 months. On the back of this we might even see some growth in Europe, but I won’t be betting my house on it.

  5. Hi Shaun, I think this is what the world needs. As an investor, for too long I have watched all regions and sectors move more or less in tandem with each other due to all the CB interference. So it’s hard to exploit market inefficiencies.

    Now, an opportunity begins to present where as you say commodity producer nations are likely to suffer for the moment (however long that “moment” may be) whilst commodity consuming nations have a chance of prospering – at last some kind of divergence in the world. I just hope the CB’s don’t start their usual performance only this time with commodities.

    I worry the Chinese may try disrupting the commodities markets with all those commercial loans Chinese companies have secured on iron ore and other commodities!!

    • I like the thinking, I hadn’t clocked he opportunity because “producer mentality” is so far from UK train of thought these days. Your concern is also valid that the Central Banks could decide, like house prices that commodity prices need to be “supported”. Just how I am not sure, some kind of stock piling or no, better a burning! Yes a burning sounds right for the 5th of November. 🙂

    • Hi Noo2

      As to the central banks I hope they stay clear of it too because it may well not be a coincidence that the retreat of many banks from commodity trading desks and operations has been followed by some lower prices! Let it lie fallow for a bit.

      At the moment the ECB seems unlikely to do anything because even if one takes today’s rumours with the whole salt cellar there is some serious dissent going on there at the moment. The Governing Council meeting will not be a fun affair this time around.

      The Chinese loans are I would imagine a factor in the weak oil price although so far they have affected the price of copper much less.

      Also just to add to our discussion of yesterday the Swiss Franc is dipping against the Euro again and is below 1.205…

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