Investment Line: eight reasons why deflation is a slow burning threat

Central banks in the developed world have adopted inflationary policies in a bid to conquer the credit crisis but deflation remains the biggest threat.  

This is the view of Capital Economics, which says that despite the recent rise in commodity prices deflation remains a significant risk in nearly every major economy.

It highlights a number of factors which are combining to put downward pressure on prices, including a decline in economic momentum with output gaps remaining large. Additionally, it said tighter fiscal policy will add to these deflationary pressures over the next two years.  

Analyst Mark Williams has identified eight key facets to the deflation threat.  

The inflation outlook is dominated by deflationary pressures

Williams expects CPI will fall gradually over the next two years with US CPI close to zero by 2012: In the Eurozone he expects prices to fall as the large amount of spare capacity in the economy pushes core inflation down to zero, while the short term VAT hike in the UK should provide short-term protection in the UK but inflation will fall back to zero as spare capacity feeds through.

Williams draws a worrying comparison with Japan. He says: ‘The medium-term risk remains unusually high. Nominal rigidities in both labour and product markets may prevent a rapid drop into deflation.

‘However, if economic growth remains as lacklustre as we fear in many countries, unemployment will remain high and the downward pressure on prices and wages will eventually become overwhelming. This is exactly what eventually happened in Japan.’  

Recovery in global demand is slowing

Williams expects demand in developed economies to slip and with the recession leaving a legacy of a lot of spare capacity which will take many years to clear.