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

Submitted By Tim Iacono
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.

When 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.

Over 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.

Anybody?

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