Wikinvest Wire

Deflation? In the U.K.? In the U.S.?

Saturday, October 18, 2008

Never before has a word in the financial lexicon been as misunderstood and/or as abused as the word "deflation".

For some reason, capitalizing the first letter of the word makes it all the more misunderstood, even threatening, perhaps due to words such as "dreary", "dreadful", and "disastrous" (to name just a few) that also start with the letter "d", not to mention the poor (but passing) grade that occasionally shows up on report cards for even the best students, a letter "D" that is invariably capitalized.

At the Bureau of Labor Statistics, where the U.S. consumer price data that could be used to prove or disprove the existence "deflation" is kept, an odd change back in 1983 saw the removal of one of the world's most important consumer prices - home prices.

Were that data to be substituted back in (as is done frequently around here), one could argue that we've had either "deflation" or "Deflation" off and on for the last year or so.
IMAGEWhen looking at the chart for "core inflation", economists' preferred measure of price changes where energy and food are excluded, it appears as though we've been running in the minus 3 to minus 4 percent for most of the year.
IMAGEOver in the U.K., the dismal scientists are scribbling furiously in an effort to predict where prices may head next year and whether they should be worried about any sort of "'flation", be it "inflation", "deflation", or "Deflation".

While the idiosyncrasies of British 'flation calculations relative to those in the U.S. are not known to me, it's pretty clear from this report in the Telegraph that some measure of home prices works its way into their price statistics.

Naturally, this begs the question of how the British could have had such a "rip-roaring" bubble in real estate earlier in the decade without setting off all kinds of alarm bells at the central bank.

Since they really seem concerned about "deflation" now, maybe they should follow the American lead of completely excluding home prices - that way you'll never see in-flation or de-flation getting away from you unless the price of rent falls, something that it looks like we'll be able to avoid for years to come, given all the excess housing that exists.

Anyway, they seem to be quite concerned:

Britain faces deflation for first time since 1960
For the first time since 1960, the cost of living will start to shrink next year, in a worrying parallel of the Japanese "disease" of the 1990s, according to new research.
The Monetary Policy Committee last week unexpectedly cut rates by a half percentage point to 4.5pc in the face of the financial crisis. However, there is also growing evidence that inflation, which has risen above 5pc in recent months, is set for a dramatic fall. The Retail Price Index – the most comprehensive measure of UK high street prices, will drop at an almost unprecedented rate to -2pc by the second half of next year, according to new research from Fathom Consulting.

It said the fall was largely due to the drop in mortgage costs and house prices, which together form a large part of the RPI. However, lower food and energy prices would also play an important role. Since modern comparable records began in 1956, the RPI has dropped into negative territory only once, in the late 1950s and early 1960s, but it only dropped as far as a rate of -0.5pc.

Andrew Brigden, economist at Fathom Consulting, said: "This does have worrying implications – particularly if it heralded a general period of deflation. The risk is we have a rerun of Japan because you simply can't [cut interest rates] to below zero."
Inflation could potentially drop to as low as minus 3 percent (which would surely be called "deflation", no?) if home prices continue to fall and energy prices remain low.

I'd still like to know how the housing bubble never showed up in their inflation statistics.


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Mike G said...


It did, actually. The RPI went from an annualized rate of 2.2 in December 2005 to 4.7 in March 2007, according to UK National Statistics.

Their technical definitions point out that they use mortgage interest payments, not principal payments, calculated from a comprehensive basket of mortgages stretching back to 1980-something, to factor house price into the RPI. They also add the effects of depreciation -- i.e., what you must spend on renovations and maintenance to maintain your house at its current value (though they use the infamous hedonic model for that.)

It seems like a fairly reasonable way to do things, but it means that wild, unprecedented skyrocketing in the overall price of housing doesn't really show up for a while, until there are 2-3 years of ridiculous, unserviceable mortgages in the queue.

Another thing it does, however, is add some positive feedback to the RPI. RPI goes up - interest rates are raised to compensate - mortgage costs go up - RPI goes up... of course, there are many more indicators, without housing, for the economists to go on, and they're smarter than that ... but it's fun to think about.

Aaron Krowne said...


We would be lucky if it happened in any sustainable sense.

Given the recent positioning of government to "monetize all the problems", and the cliff the dollar is peering off, I don't think we will be.

Aaron Krowne said...

I should also point out that nominal home price declines don't necessarily bear much resemblance to actual affordability.

That's because while prices have dropped a lot -- weighed down especially by the most "frothy" regions -- prices in other regions have not fallen as much, and more importantly, credit has been scaled back dramatically. The pool of those who qualify for "the average mortgage" is now much smaller.

Resultingly, huge chunk of people who could formerly afford homes at a distance they could afford to drive still cannot. The metrics have not caught up to this.

The upshot is, any metric that would imply we are seeing a comprehensive "deflation" is pretty far divorced from reality.

Just ask yourself the ratio of people complaining about rising costs to those rejoicing about all the cheap homes and cars they can now buy, within the past year.

dearieme said...

Yes, the RPI for Britain contains a component related to housing cost. Mr Brown, when he was Chancellor of the Exchequer, replaced RPI by CPI as the inflation index to be targeted by the Bank of England. And the CPI excludes housing costs. Fiddling dishonestly with calculations of inflation is not solely an American habit.

Anonymous said...

Arab and Muslim leaders expressed joy over the American economic crisis.
Palestinian prime minister Ismail Haniyeh (pictured in a file photo) told Muslims at a Gaza mosque Friday: "We are witnessing the collapse of the American Empire. What's going on in America is a result of the violation of the rights of people in Palestine, Somalia, Iraq, Afghanistan and Muslims around the world."

Iranian President Mahmoud Ahmadinejad earlier this week joined the chorus of muslim delight over the American economic crisis and said that Americans are "oppressors...Systems based on oppression and unrighteous positions will not endure."

An Iranian senior cleric, Ayatollah Ahmad Jannati, declared: "We are happy that the U.S. economy is in anarchy and the anarchy is reaching Europe."

little larry sellers said...

Anon 6:42,

Who cares? Given how eager we are in the West to knife each other in the back in the name of short term profit, why should anyone else in the world care about us? We obviously don't even care about ourselves!

We're about to get knocked down a few pegs, and we richly deserve it until we attempt to build a real economy again. We need to reject this phony economy based almost solely on debt and consumer spending.

Even worse, in a few weeks we get to choose between two presidential candidates, neither of whom has the SLIGHTEST inclination to deal with the underlying problems of our economy. Sad times for us, but we deserve them until we pull our heads out of our collective rear ends. We could have had a leader like Ron Paul, but nooooooo, we didn't want that.

Anonymous said...

we should just get rid of the "de" and the "in" and call it Flation. the letter "F" has a much more appropriate connotation than the letter "D".

ndd said...

Thanks, Tim. I am actually a little surprised that the CS-CPI isn't significantly negative yet, given the 15%+ decline in house prices, and the sudden collapse in oil prices.

Worth revisiting in a month or two if the collapse in commodity prices continues.

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