Inflation, Deflation and the Jabberwocky

by George Hatjoullis

The recent pronouncements by central bankers, and some economists, about ‘good’ deflation and ‘bad’ deflation brought to mind Lewis Carroll’s wonderful nonsense poem, Jabberwocky. At no point during the great inflation of the 1970s did anyone mention ‘good’ inflation and ‘bad’ inflation. Why the asymmetry? Moreover, all policy targets seem to define ‘price stability’ as inflation at 2% or thereabouts. If some inflation is good then how can any deflation be good also? When central bankers start speaking of the inflation monster in nonsense verse, households should worry.

It gets worse. The inflation discussion is always in terms of the rate of change of so-called ‘representative’ price indices. Yet none of these indices represent any household or class of households. The ‘representative’ index for a single girl living in rented accommodation in London has little in common with the index for a two-parent family in Carlisle. The construction of these indices is also a little arbitrary as one can discern by comparing construction across continents. The US CPI and sub-indices place a large weight on something called ‘owners’ equivalent rent’. Households that own their property are asked;

“If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?”

Some average of responses is then entered into the index. Jabberwocky! A little digging will reveal that this component is a very large part of what US households are told is ‘core’ inflation. Please draw your own conclusions.

The whole concept of ‘core’ inflation as discussed today is a distortion of the original theoretical concept. This has been discussed in an earlier blog (Understanding ‘Core’ Inflation, Jan/16, 2015) under the Economics category so I will not labour this point. Suffice it to say that the only measure of inflation that makes any sense (to me) is the GDP price deflator and this index rarely sees light of day. One reason is that GDP data are rarely calculated more frequently than every quarter and are subject to huge revisions. Nevertheless, the deflator is the correct concept. The weights are whatever is produced in the economy. The prices, by and large, are based on actual expenditure. It may not be perfect but it is as good as it gets. Moreover, it is representative. It represents the economy.

Japan Historic Inflation Data

The above chart is of the rate of change of CPI in Japan taken from ( The great Japan deflation, which no one doubts and to which everyone refers, did not actually involve a very dramatic fall in the CPI. Yet it was a very real deflationary period. How so?

The problem is the obsession with price indices as measures of inflation. Inflation and deflation are states of mind. It is about fear. During periods of inflation households try to hold wealth in the form of assets that are either indexed to prices or typically correlate with prices. Nominal wealth asset holdings are avoided where possible and liquidity balances kept to a minimum. Households are happy to borrow in an inflation, so long as repayments are not price-indexed.  In a deflation the opposite tendencies would be observed.

In a deflation households are happy to hold wealth as cash or near cash. Of course, they wish to avoid credit risk so the near cash assets need to be credit-risk free. So the preferred assets would be cash, bank deposits up to the insured balance, and government debt assuming a separate currency issued by a national central bank (i.e. not necessarily eurozone sovereign debt). They will also hold assets that they deem to be risk free or are secured on pools of risk free assets. Borrowing is avoided.

In a deflation, demand for nominal, or ‘money’, risk-free assets is high. If the fear is sufficiently intense investors will pay for the privilege of lending; interest rates can go negative. This is not as daft as it sounds. If you fear falling prices then lending at a negative interest rate may still provide a positive expected real yield. So one important signal of deflation (good or bad) would be widespread incidence of negative interest rates and bond yields. I know of no period in history in which negative interest rates and bond yields have been more prevalent and widespread that the present. I rest my case.