April 18th, 2014 by Hafiz Noor Shams
There is a curious logic going in the market and I am guilty of it myself. I only realized of my contradictory views only after I read a view claiming deflation encourages consumption spending (Austrians…) and asked myself a few questions about inflation/deflation.
To properly highlight what I see as a contradiction, answer the following question: does inflation discourage consumption and spending?
Keep your answer in mind.
Now, answer the next question: does deflation encourage consumption and spending?
The two questions are deeply connected with each other. They are the two sides of the same coin.
If you answered yes for the first question, your next answer should be yes if you’re consistent.
If you answered no for the first, you should answer no in the next.
I had answered the first question in the affirmative: yes, inflation discourages consumption. That I think is the market view in Malaysia right now. Ask economists in the financial sector and that would likely be the answer.
When I asked myself the second question, I immediately answered no when if I was consistent, I should answer yes. The answer no is probably the monetarist in me screaming, “what kind of question is that?” It is a reflex and it does not even go through my brain.
To address the two questions, I assume wages do not change. It is a simplification to make the analysis clearer. Adding wages will not change the analysis much but only complicates the explanation. Besides, you can always rely on wage-price spiral logic to control for wages although, with stickiness especially in times of deflation, it does present a problem. But that appears off-tangent for this entry of mine today.
So, with that out of the way, the yes answer is relatively easy to justify:
- If inflation is the reality, then you would feel poorer. You could afford to buy fewer things.
- If deflation is the reality, then you would feel richer. You could afford to buy more.
But it is not that simple. The set of answers (inflation discourages spending, deflation encourages it) is only applicable for one-time game/statics. For a more dynamic situation, the answer would be the reversed:
- If inflation is the reality and you know inflation would remain in the foreseeable future, then it makes sense to consume now. You know that if you do not and you save it instead, the real value of your savings will diminish no thanks to rising price levels. In an inflationary environment, savers get screwed. Sure, that does depend on the interest rate on savings but inflation is still bad for savers. It is the complete opposite for spenders. In inflationary times, it is better to spend. In Malaysia, you are already losing out if you save in a fixed deposit, if the consumer price index as the benchmark of inflation. Interest rate on 12-month deposit is 3.15% in February. Yields on one-year government bond is 3.05%. Compared that to about 3.5% YoY CPI inflation in the same month. It is a bad time to save. If you do want to save and make sure your real savings do not diminish, you have to reach out for the yields, investing in some mutual funds or even go straight to the stock market.
- The reverse is true for deflationary environment. You know prices are falling down and the rational thing to do is to delay your consumption to later and later so that the prices of whatever you will be consuming get cheaper. You should prefer to save because with each day prices fall, your savings will become more valuable. Deflation is really good for savers but bad for spenders. Such situation depresses spending as people prefer to save.
My problem here is that I have accidentally mixed the two views (half one-time view and half repeated game view) together and I think the Malaysian consensus has done the same too. I do not think professional economists would think deflation is good for consumption growth. I think I am right to say that there is some consensus among economists, at least in the financial service circles in Malaysia, that the rising inflation now, more or less meaning the rising cost of living, is hurting private consumption. At my work, we have a propriety index that suggests discretionary spending is growing slower and the slowdown is coinciding with the subsidy cuts that are causing the rising domestic inflation. Bank Negara Malaysia, the monetary authority, has incorporated weaker domestic demand into its 2014 projection too. It is hard to think of anything else that is causing the weaker consumption. You could say it is caused by the government fiscal consolidation but that is exactly being operationalized through the subsidy cuts, mostly.
I see the contradiction but I have trouble reconciling them.
And I think this is a serious contradiction. These are not policy entrepreneurs-lobbyists with limited training in economics. These economists know their economics and the contradiction exists. Why?
Is there something that I missed?
The Euro area inflation came lower than expected in March and this has raised concerns about deflation (or “lowflation” as labelled by the IMF). In today’s Financial Times, Jurgen Stark, a former ECB board member argues that deflation or low inflation is not a problem. One of his arguments is that there are benefits for low inflation, in particular:
“It is likely we are living in an extended period of price stability. This is good news. It boosts real disposable income and will eventually support private consumption.” [Antonio Fatas. The Price is Wrong. April 14 2014]
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