It is now clear that central banks were basing monetary policy in the first half of this year on the forward oil futures curve, which had the oil price stabilising at $US120 a barrel, as well as a continuation of the China boom.
It is now clear that central banks were basing monetary policy in the first half of this year on the forward oil futures curve, which had the oil price stabilising at $US120 a barrel, as well as a continuation of the China boom.
The collapse in the oil price since July to $US55 caught them by surprise. Suddenly they are no longer worrying about inflation, but deflation instead, and this switch has occurred with incredible speed.
This morning comes news that consumer prices in the US fell 1% in October, the largest ever fall.
Yesterday the Governor of the Bank of England, Mervyn King, said it was “very likely” that inflation in Britain would turn negative next year and there was “obviously” a risk of deflation, which is why the Bank of England cut interest rates by 1.5% this month, its largest ever move.
In speeches over the past 24 hours, various central bankers, including RBA Governor Glenn Stevens, have fingered the collapse of Lehman Brothers as the moment when the earth moved for them and previous monetary and liquidity policies had to change.
But when the history of this time is written (and written, and written) it is likely that the unexpected collapse in the oil price will be seen as more important.
Here’s what Stevens said in his speech to CEDA last night: “What had been for over a year a serious dislocation in international financial markets, but one which seemed to be being managed, turned quite suddenly into a very serious crisis during the weeks following the failure of Lehman Brothers on 15 September.
“In a breathtaking turn of events, the financial landscape changed dramatically, with the failure or rescue and effective nationalisation of a number of systemically important financial institutions in the United States, the United Kingdom and continental Europe. Sharemarkets slumped, currencies moved abruptly, commodity prices continued their sharp decline and investors’ appetite for risk contracted further.”
There was also a speech last night by the Deputy Governor of the Bank of England John Gieve, in which he said the collapse of Lehman Brothers led to a “dramatic loss of confidence”.
Note the word “continued” by Stevens in relation to commodity prices; that it had already been happening. Lehman’s collapse might have devastated asset markets, but commodity prices were already in free fall.
The tightening of the credit squeeze in mid-September reduced the effectiveness of monetary policy because market interest rates shot up and banks stopped lending. The official cash rate target became a sideshow.
But it did not eliminate inflation. That has been achieved by the collapse in commodity prices, and in particular the oil price.
Central banks are trying to fight consumer price deflation with the equivalent of a popgun. Their only weapon is the cash rate target’s impact on aggregate demand, but the actual interest rates that consumers and businesses are paying are not coming down to anywhere near the same extent and demand is still falling because banks are rationing credit and confidence is collapsing.
The problem with consumer price deflation is that has a more immediate and devastating impact on the debt burden than asset price deflation. (The exception to that is where firms have to mark their assets to market in their balance sheets.)
As prices and therefore incomes fall (not wages at first, but business incomes) debt doesn’t change. Its relative value rises and it becomes more difficult to service.
During previous deflationary episodes, in particular the 1930s, there was much less household debt than there is now. In Australia household debt is now 160% of disposable income – almost triple what it was just 12 years ago and many times what it was 80 years ago; in the 1930s depression few people actually owned their own home.
The other problems with deflation are that it causes consumers to hold back and wait for lower prices later, and it redistributes wealth from borrowers to savers, reversing the intended affect of the reduction in official interest rates.
All of these things are hard to reverse once they take hold, which is why it’s often referred to as a deflationary spiral. Japan had it in its “lost decade” of the 1990s, and never decisively pulled out, so that deflation is threatening there once again.
Stevens concluded last night by urging us not to talk ourselves into “unnecessary economic weakness”.
OK, I’ll shut up. But you know things are crook when central banks are reduced to giving pep talks.
This article first appeared on Business Spectator
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