Inflation measures how the cost of living changes through time. Goods that you could buy for 1 today might cost 2 at some point in the future. In the UK, cost of living is recorded in the form of the UK Retail Price Index (UK RPI). The level of this index is simply the price of a standardised basket of the most common consumer goods. The UK RPI is recalculated at monthly intervals.
The following chart shows us how this measure of the cost of living has changed over the last century - notice that the series is presented on a proportional scale. The UK RPI shown in this chart has been re-based so that its value in 1900 is 1. The chart shows that the cost of living in the UK has increased approximately 54 times since 1900. Conversely, we could think about this, the other way round, in terms of the buying power of money: over the last century, the buying power of 1 has fallen to less than 2p.
The annual rate of growth in the cost of living, as measured by the UK RPI, is called the rate of inflation, or simply inflation. Inflation measures how much, in proportional terms, the UKRPI changes from one year to the next. It is usually expressed as an annual percentage increase. As an example, between 31 Dec 1969 and 31 Dec 1970, the UK RPI increased from 5.8 to 6.2. This change represents an increase of 7.9% during 1970. We would say that in 1970 inflation was 7.9%. If we plot this annual inflation rate, rather than the level of UK RPI, we get a rather different looking picture. Unlike UK RPI, inflation represents a proportional change, and is plotted on an ordinary linear scale. UK inflation rate 1900-2000 (linear scale)
Although the general trend is for the cost of living to rise, during the 1920's and 1930's the cost of living actually decreased. A fall in the cost of living is referred to as deflation and corresponds to negative values for inflation (see the chart above). Although periods of deflation are rare, they do happen, and we cannot predict when. Although it is unlikely, it is quite possible that may be experienced deflation in the UK at some point in the next decade or two. Equally, although the current rate of inflation is fairly stable at between 2% and 3%, it is quite possible that inflation may increase substantially in the future.
LOWER PETROL PRICE
Ironically, the main reason for the decrease was a fall in the cost of petrol, which fell compared to the sharp increases that occurred one year ago, when the first effects of the oil price rise were beginning to be felt. The National Statistics office said that petrol prices were likely to increase again in September. But downward pressure on prices also came from seasonal foods, although clothing and footwear prices recovered after falling in the summer sales. The measure of inflation used by other European countries, the harmonised index of prices, which excludes taxes and housing costs, also fell to a record low of 0.6%, the lowest in the EU. The underlying rate of inflation has now been below its target for seventeen months.
RATES ON HOLD
The low rate of inflation has led the Bank of England's monetary policy committee to keep interest rates unchanged for the last seven months at 4.0%. One of the factors that has helped keep inflation in check has been the high pound, which has lowered the price of imports - although it has also hurt manufacturing exports. Some economists warned that the Bank could still raise interest rates later in the year.
"I think it provides a justification for continuing to hold interest rates because there is that margin of safety between actual and targeted inflation. But we still think the MPC will raise interest rates one more time before the end of this year," said Michael Taylor of Merrill Lynch. One reason may be the further pressure that could be put on prices by the falling pound. In the longer term, the pound's weakness against the dollar could increase inflation, as imported goods from the United States will become more expensive. However, as long as the Euro continues to be weak, the effect on inflation is likely to be limited, as the UK imports more from the EU than anywhere else.
WHAT IS DEFLATION AND WOULD IT BE A PROBLEM
The subsequent decade has been a period of low inflation almost everywhere. Most recently, with a global business cycle downturn, inflation globally has declined further, and is currently low to very low in most places. So it is natural to ask whether, after a generation worrying about inflation, we might be faced with deflation. Certainly the word 'deflation' is used with much greater frequency than it has been for a long time. Its use usually conjures up some vague notion of the Great Depression, which was the last time a widespread deflation occurred.
Deflation is a generalized and persistent decline in most, if not all, prices for goods and services. More likely than not this, if it occurred, would be accompanied by declines in prices for many real assets and pressure for, even if not the actuality of declines in wage and salary incomes. A situation where we observe declines in the prices of some products does not qualify as deflation in this sense. It is nearly always the case that prices for some things are falling, while prices for other things are rising.
A simple but useful working definition of deflation, then, is when the prices of enough goods and services decline to cause aggregate price indices like the CPI to record a fall. Deflation of that general nature was once a not-uncommon event. For example, in the 19th century, it was normal to think of a relatively stable average price level over fairly long periods, but with noticeable fluctuations around the mean over periods of some years - with periods of inflation being followed by periods of deflation. Deflation need not be harmful. In cases where exceptionally strong productivity growth accompanies very strong demand growth, the price level can fall even as beating deflation can only be achieved by restoring the Japanese economy to a sustained recovery path. To this end, revitalising private demand through structural reforms such as tax system reform is indispensable.
Although Japan successfully navigated its way through the fiscal year without a crisis, the banking system remained in sever condition. Due to the bad loans, the weak Yen currency, downward pressure from export and inventories and weak domestic demand, economic recession. The prices would go on declining. It's a good idea to support the stock market first. This is the practice of betting on a falling market in which a seller sells shares they do not yet own in the expectation they will be able to buy them back more cheaply later on.
Driving up the stock market is intended to support the banks. Japan's banks must write down the value of their portfolios to current market values. They have taken such action several times in recent months, with little impact. In addition, the banks should keep loaning in order to strengthen the currency liquidity, also strengthen the credit and adopt a more forward-looking approach to loan classification and provisioning. Anyway, just be more careful than before on loaning to avoid bad debts.
The most common way to deal with deflation injecting money into the market. So the more we have, the higher price will be strengthened. But many people are concerning about the currency devaluation caused by the expansion of the amount of money. Let's see what Japanese had done. They had devalued their currency. Due to the devaluation, people from abroad are much willing to buy the "Made in Japan". At the beginning, there may be a trade deficit. Once the change of quantity overwhelms the change of price, trade surplus will appear. So in long-term, this will be a successful strategy to take in money for the use of curbing deflation.
Structural problems lie at the heart of Japan's economic difficulties. For more than a decade Japan has adjusted too slowly to the forces of globalisation, lagging behind in productivity growth. The country must remove the obstacles to efficiency in the domestic sectors of the economy. They also need to introduce measures to strengthen the regulatory structure improve corporate governance, increase labour market flexibility. Such policies will be important to generate new investment and employment opportunities, and raise productivity growth over the medium term. From deflation to structural reforms, none of them will be easy to implement, but bold measures are needed to return the economy to strong, sustained growth. The past decade has proved that the risk had been delayed.
Why might deflation be harmful? The main reason is because of fixed nominal contracting of wages, debts, etc. The real value of a dollar is higher after deflation than it was before. So if you owe a pound, your debt burden is higher. If you are owed a pound, or earning a pound, your real wealth or income is higher. Price changes of this nature, if they are unanticipated, lead to a different distribution of wealth and income than people had banked on when they made their contracts. Usually, this is disruptive to the economy (not to mention unfair). This is a problem of exactly the same nature as those, which arise with inflation, except in reverse. In time, of course, people learn that price changes are occurring, and adjust their behaviour accordingly. But adjusting incomes downward for deflation is typically harder to do than adjusting them upward for inflation. So percentage point for percentage point, deflation is arguably a bit more painful than inflation.