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Warding off the threat of deflation

WHILE expectations of price pressures over the next 12 months are largely on the upside, the potential threat of deflation also will be of concern to the Reserve Bank of Australia.

Deflation already is a real threat in the United States, as a result of a sharp decline in business investment, production and capital utilisation, and Australia may not be totally immune to price deflation if economic conditions continue to deteriorate. This is despite the remarkably resilient performance of the domestic economy.

BankWest economist Alan Lang-ford believes that, at least in the short term, downward price pressures, if not deflation, may be a possibility, although in the medium to long term, prices were likely to gain ground.

“Normally, central banks are fighting inflation because demand outstrips supply, and at the moment this is not the case,” Mr Langford said.

“The RBA would like to think it has almost done enough to underwrite the local economy’s growth next year, but like the Fed, its bias remains tilted towards another lowering of the cash rate in the first half of 2002.”

But the odds appear stacked in Australia’s favour when com-pared with the US.

Domestically, business investment has managed to hold ground, whereas in the US it has continued to fall as cash exits the over-valued technology industry.

“When the Nasdaq was booming, Australia’s modest exposure to the IT revolution was seen as a millstone by the global investment community, but the absence of over-investment in IT capacity down under is now a relative virtue,” Mr Langford said.

Also counting in Australia’s favour is strong consumer spending and housing demand, while production cut-backs also have not been as severe as has occurred in the United States.

Chamber of Commerce of WA chief economist Nicky Cusworth believes underlying inflation, which takes out the GST effect and other anomalies, is showing signs of continued strength.

“If you look at the underlying prices you will see that there is some inflationary pressure,” Ms Cusworth said.

“Even though there is talk of deflation in the United States there is not much risk of that here. The United States has its own unique economic circumstances.”

During the September quarter, underlying inflation increased 0.7 per cent to be up 2.9 per cent for the year. Pushing prices was a 1.6 per cent increase in domestic demand during the quarter, while business investment steadied to increase 0.3 per cent, although still down more than 10 per cent from a year earlier.

But what if the economy continues to deteriorate and deflationary talk becomes a reality, not only in the US, but locally?

Mr Langford said it would cause a further fall in consumer spending as the public plays a waiting game, expecting goods to be cheaper in the future.

Business investment also would fall on expectations of a drop in the cost of capital expenditure and business assets declining.

Those with personal or business loans also will be hurt.

The cost of debt servicing would increase as investors continue to pay off a loan on a falling asset.

The Government’s ability to stimulate growth in the face of deflation is also hampered as monetary and fiscal become a less effective instrument – the ongoing situation in Japan being a case in point.

However, with the Australian cash interest rate still well above zero, the RBA still has more scope to counter any deflationary pressures, as opposed to the US, where interest rates are more than two percentage points below local rates.

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