A lot of attention has been focused on consumer prices recently as economists try to determine if deflation or inflation is going to be the next challenge for the OECD economies to deal with. On the surface it would seem that due to falling asset prices, unemployment and the decline in personal wealth that this would push many of these economies into a significant period of deflation. But is that really likely to happen?
When looking at economic data it is important to appreciate that it only tells us part of the story and in addition to the number crunching that economists do, there is also a lot of more up to date raw data that is just as valuable. For example economists often comment about retail sales figures but the data they usually have in front of them is sometimes weeks or months old, whereas the raw weekly sales numbers from a major retailer can often be much more useful in spotting trends early.
Similarly data collected by organisations like the OECD can be quite dated and by the time a report is published economic trends may have moved on in another direction. I make this point because it is important for investors to understand that any trend shown by past data can be reversed when the next batch is released, or may have already been reversed by the time we read the report!
Taking the above into account what are we to make then from the fall in consumer prices 0f 0.1% across the OECD over the 12 months up to June 2009? Is this telling us that many of the OECD nations are entering a extended period of deflation. Well not really.
OECD Consumer Prices 2002 – 2009
At first the graph above seems to indicate a significant drop in consumer prices across OECD nations and in fact it does if we include food and energy prices. But as the dotted line shows, if we exclude these items the movement in consumer prices is not nearly as dramatic.
Commentators and analysts who may wish to suggest deflation is looming often show only the total movement in consumer prices which is fair enough, but I believe it is important to dig into this data in a little more detail before any conclusions are drawn.
So is it food, energy or both that are dragging consumer prices down at the moment? According to the OECD report:
“Much of the recent trend inflation has been driven by the volatility in oil prices, which touched record highs over the summer of 2008, highlighting the need for care in interpreting the negative figure for June 2009. Consumer prices for energy were down by 15.5% in the year to June 2009, following a fall of 16.0% in May. etc.”
Yes my friends, consumer prices are being dragged down largely by the collapse in oil prices just as they were given a nudge up by high oil prices back in 2008. (along with higher prices for just about all commodities back then)
In Australia, the CPI in the 12 months to June 2009 rose 1.5% but food prices rose 4.7%. What kept the overall figure down was the drop in the energy CPI component which fell by 12.3% and this is mainly due to oil prices.
Across most of the OECD food prices actually rose 1.8% so it is pretty clear oil is the reason consumer prices fell. So how likely is it that oil prices will continue to fall and this keep dragging down prices? Not very likely in my opinion.
Oil prices have been creeping up now for some months and so it seems plausible that oil will move past $80 a barrel this year. If this were to happen then consumer prices across the OECD (and in Australia) would be pushed up and as things stand today, I doubt the next report from the OECD will show consumer prices fell in the second half of 2009.
The consumer prices report from the OECD strengthens my belief that in Australia and indeed many of the OECD nations (Japan being a notable exception) are not heading for a deflationary spiral but rather will need to deal with rising inflation.
A key factor in determining how events unfold will be oil prices and therefore if they continue to recover then I would suggest that interest rates in Australia will rise and inflation will become a problem for the Reserve Bank and Government.
Cranking up interest rates will indeed help fight inflation but it could also dampen any economic recovery, it is a delicate balancing act and the wrong policy decisions could send the Australian economy backwards. The RBA would be aware of this and hence the reason I guess that they have not moved rates for a while.
But there is a chance of course that oil prices could fall on the back of some bad news about the U.S. economy (the world greatest consumer of oil) or signs that the global recovery is slowing or even grinding to a halt. So nothing is certain, we just have to make the best assumptions we can and see what happens.