We examine whether the UK is experiencing stagflation or a deflationary recession.
A stagnant economy, dysfunctional financial system and five-year government bond yields under 2% are all indicative of today's UK economy – and Japan's in the 1990s. Back then, after the great stock market crash the equity market fell by 60% in just two-and-a-half years (1989 to 1992).
Looking back at Japan
In marked contrast to Japan though, UK inflation – or at least headline inflation rates – is still relatively robust with the Retail Prices Index (RPI) and Harmonised Index of Consumer Prices growing at 5% and 4.2% year on year (y/y), respectively. It should be noted however that Japanese inflation did not turn negative y/y for nearly five years after the stock market peaked (finally turning negative in July 1994) because inflation nearly always lags behind real economic activity.
Conventional leading indicators of UK inflation, such as money supply growth (down 0.2% y/y at the end of May) and real wage growth and economic activity levels (approximately -2% y/y) suggest lower inflation rates lie ahead. Not least because most of the increase in inflation in the last two to three years has been down to either VAT increases, exchange rate weaknesses or higher commodity prices. That UK GDP levels are nearly 4% below the peak achieved before the credit bust in 2008 reinforces this. So it is hard to argue a case for monetary tightening – even for those concerned that the UK trend growth may have fallen sharply since the credit boom – particularly as inflation expectations appear stable (implied by breakevens in the gilt market).
Structural headwinds from the deleveraging of debt accumulated over the past 15 years, by both consumers and the UK Government, continue to bear down on the recovery. Also, the reluctance of the banks to mark impaired assets to market, and the willingness of regulators to accept this treatment, sometimes known as 'pretend and extend', leaves little room for new loan growth, even where there is demand. This draws clear parallels with the Japanese policy response in the 1990s and 2000s.
Risks of deflation
If the economy faces a sub-par recovery, characterised by debt deleveraging and weak demand growth, what are the risks of outright deflation of the price level?
Deflation episodes are rare in the UK. The RPI showed negative y/y inflation for nine months in 2009, but that was the first time since the 1930s. Both deflations in the 1930s and 2009 were accompanied by extreme financial dislocation, but policy responses were very different.
In 2008/09, the Bank of England moved quickly to combat deflation by printing money, allowing sterling to depreciate and buying approximately £200bn of gilts (about 14% of GDP). In contrast, in the 1930s the UK did not leave the gold standard (despite the Bank of England losing gold from July 1931) until it was forced off in September 1931 after the Invergordon Mutiny. Even after leaving the gold standard, the prevailing policy wisdom at the UK Treasury and the Bank of England in the 1930s was that the ghosts of inflation were everywhere. As such, UK monetary policy was not expansionary until 1932.
In 1936, John Maynard Keynes published The General Theory of Employment, Interest and Money arguing for aggressive fiscal expansion. There was no quantitative easing programme and the bank rate was never reduced below 3%. An increase in the money stock was largely due to capital inflows not deliberate monetary policy. UK monetary policy from 2009 onwards, a weaker sterling exchange rate and a willingness to allow a prolonged workout in the financial system reduce the risk of outright deflation in the price index, even if a prolonged period of disinflation and debt deleveraging are likely, with very low credit growth.
Lessons learnt
The important lesson learnt from the emergence of deflation in Japan is that the central bank needs to be proactive in injecting additional liquidity into the system if a highly indebted economy starts to falter. Fortunately, both the UK MPC and US Federal Reserve are well aware of these risks. Consequently, if domestic consumption fails to recover and consumers defer spending, particularly with fiscal policy being tightened, another dose of quantitative easing is likely.
Asset classes like index-linked gilts should continue to perform well in this environment, since a period of weak real economic growth alongside 3% RPI accruals is likely. Meanwhile, real yields are turning negative for much of the yield curve, as they are now for conventional gilts.
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