Dash to Deflation

Today’s Consumer Price Index suggests that Canada is lunging toward deflation. The annual inflation rate plummeted to just 1.2% in December, 2.2% lower than only three months ago. If this pace continues, the national inflation rate will turn negative in the next few months. Two provinces, Nova Scotia and New Brunswick, already recorded negative inflation rates in December.

Of course, a large drop in gasoline prices pulling down the Consumer Price Index does not necessarily constitute deflation. The key question is whether there will be a sustained, generalized decline in prices. Since fuel is an input to so many other goods and services, it is possible that December’s huge drop in gasoline prices (the largest ever recorded in Canada) will put downward pressure on other prices in the coming months. In other words, the threat of deflation is real.

Another consideration is that recessions almost always reduce prices. Between 1982 and 1983, the inflation rate fell by 5.1%. Between 1991 and 1992, it fell by 4.2%.

The release of figures for December 2008 reveals an inflation rate of 2.3% for the whole year. If the experience of previous recessions were applied to this starting point, Canada would experience deflation ranging from -1.9% to -2.8% in 2009.

While deflation would be a boon to those consumers who retain their incomes, it could deprive many Canadians of their jobs. If many consumers delay purchases in anticipation of future price reductions, firms will reduce output in response to fewer purchases. The correspondingly lower level of employment would further depress consumer spending, forcing further price reductions and perpetuating the deflationary spiral.

Today’s figures confirm that the Bank of Canada should have cut interest rates further than it did on Tuesday. They also indicate that the federal budget should inject more public spending into the economy as opposed to providing tax breaks that might well be saved (rather than spent) in anticipation of even lower prices in the future.

UPDATE (Jan. 24): Quoted by CanWest

2 comments

  • And the bonus is that right-wingers are equally upset about the prospects of deflation, per several Economist articles in the early millenium. So we’re closing in on an era where everyone agrees on a stimulus equalling 2% of GDP and dropping interest rates to zero until inflation goes into the positive.

    Does everyone remember the last time they wished everyone were more left wing? Well, be careful what you wish for. With any luck we can hold onto this virtual consensus after the economy turns around. It would be nice if there were some kind of coalition government advancing this consensus, relegating the free-market ideologues to the opposition.

  • Who knows what will happen but, as you point out, almost all of the downward pressure is coming from gasoline prices, which have already started to inch back up. Food prices remain strong and the core rate has been steady at around 2.4%.

    Keep in mind the the GST cut in January 2008 pushed the headline 12 month rate down. This effect will disappear with the January 2009 report and the headline rate will be much closer to the core. Add it all up and I don’t see any threat of negative territory anytime soon.

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