Renewed deflation worries

Dollar bills of various currencies Image copyright AFP

Inflation is nearly at five-year lows in major economies. In other words, price rises are as weak as during the global recession. It doesn't mean that we are returning to recession, but it raises the danger of deflation once again.

When prices fall, it can be hard to get out of a deflationary trap, as has been seen in Japan which has coped with deflation for more than 15 years. It's because consumers put off purchases if they think that prices will be cheaper in the future.

Lower demand leads to less production and firms employ fewer workers. A weaker job market discourages purchases which don't support price rises.

And prices look low around the world.

The latest figures for China show that prices rose by 1.6% in the year to September.

Even India, which had problems coping with inflation of nearly 10% just a year ago, now faces inflation of just 2.38%.

For the UK, inflation has slowed to 1.2%, which is the ninth month that it has been below the Bank of England's 2% inflation target.

Across the channel, inflation in the eurozone is just 0.3%.

No wonder the European Central Bank has started a new programme to inject cash in exchange for buying asset backed securities. This is while the US ends its QE, or quantitative easing, programme this month.

However, low inflation at 1.7%, together with weak expected inflation, complicate the picture for the Federal Reserve - the central bank for the US. After the end of QE, the next step is to get interest rates back to normal, or at least back to above zero.

But with deflationary pressures in the US and worldwide, the timing is tricky.

If inflation remains below target because of weak growth, repayment of debt and falling commodity prices - which also feed into each other, then for central banks that target inflation it is not straightforward to think about raising rates even gradually.

Multiple tools?

And if deflation sets in and interest rates are already pretty much at zero, then rate cuts won't be possible. That's why unconventional tools like QE were deployed in the first place.

Of course for China and India there is scope for rate cuts. And China has already begun to ease credit conditions to support the housing market.

Due to having a fixed exchange rate, China has had to manage the money supply to keep the renminbi within the managed range. Interest rates were never the only tool and the Chinese central bank has always used other policies to control credit and money.

Those macro-prudential tools are increasingly found in the toolkits of other central banks that now look at credit and debt, as well as inflation.

A bigger toolbox is likely to come in handy in any case as asset prices (housing, stocks) remain high while the overall economy experiences deflationary pressures. One tool can't fine-tune a multiple speed economy.

We may soon get to see what else is in the toolbox of central banks.