Bernard Hickey explains why falling inflation expectations falling towards 0% and below is problem for everyone and why the Reserve Bank should care and act

By Bernard Hickey

What could possibly be wrong with falling prices?

That’s a question we’re all having to ask ourselves now as global deflationary forces gather strength and force central banks and Governments into all sorts of awkward places. 

Central banks in the Euro zone, Sweden, Japan, Denmark and Switzerland now have negative interest rates on the money deposited with them by banks. Banks are having to pay to park their money. Some of those banks are beginning to charge their biggest clients for the privilege of keeping their money in the bank.

It is creating all sorts of weird incentives. It’s actually beginning to make sense to take your money out of the bank in these countries and stash in bricks of cash under the bed or in a safe. People with billions are now doing their sums on how expensive it is to store their savings in cash in their own vaults. At some point, the negative interest rates will fall low enough that it makes sense to build vaults, employ body-guards and buy a whole lot of suitcases with big locks. It’s one of the reasons why the European Central Bank has just announced it is looking at withdrawing the 500 euro note from circulation. It wants to make it harder for people to avoid these negative interest rates.

Negative interest rates also upturn all the old expectations about cashflow and early payment of bills and taxes. In the days when there was a bit or even a lot of inflation, it made sense for Governments and businesses to encourage early payment because the sooner the payment was made, the sooner the cash could be spent to avoid being eroded by inflation and the sooner the cash could start earning interest. 

In a world of deflation and negative interest rates it actually makes sense to encourage people to delay paying their bills because money in the hand later is more valuable than sooner when you can more stuff with it later. Last month the Swiss local Government of Zug scrapped its discounts for early payments of taxes and told ratepayers to delay paying so the Government could avoid putting the money in the bank and having to pay interest on the deposit.

Very quickly, cash starts to flow more slowly around the economy and hoarding begins when expectations change about the future value of money — either as a store of value or a way to buy things. When deflation sets in, it makes sense to hold on to your money rather than spend it. The thinking of consumers and businesses changes in a way that most of us haven’t considered. 

For example, banks struggle to make profits in world of negative interest rates. They have to pay the central bank money to look after their reserves because they have no choice — there’s only one central bank. But they find it very difficult to then charge their own customers to look after their deposits. Some Swiss banks have tried, but have only succeeded with a few clients with very, very large deposits who are unwilling, for whatever reason, to take their money out of Switzerland. This is why when the Bank of Japan cut its bank deposit rates into negative territory last week financial markets reacted surprisingly badly to what was actually easing of monetary policy. They became worried that bank profit margins would be cut even more, making the banks riskier and shakier in the long run.

Businesses also become more nervous about investing when they see prices falling. That’s because they also squeeze their own profit margins. As their competitors cut prices, they have to find ways to cut their costs even faster. Cutting wages is surprisingly hard, although it has begun happening in places with entrenched deflation such as Japan. 

Everyone agrees that deflationary expectations are a bad thing, which is why our Reserve Bank watches inflationary expectations very closely for any signs they are losing their moorings and starting to fall towards zero, or lower. This week the Reserve Bank’s own survey found one year ahead expectations fell this year to a record low of 1.09% from 1.51% and two year ahead expectations fell to a 22 year low of 1.63% from 1.85%. 

This is why the drums are beating again for the Reserve Bank to cut interest rates again as early as March 10. The Reserve Bank cannot afford to let expectations about inflation fall and it’s not surprising they have fallen. The prices of goods in the shops have been falling for three years and the most prominent price in people’s minds — the price of petrol — is falling too.

Just as for any shop, falling prices make sense for a short while to clear stock and bring people through the door for the first time, but continually falling prices are a dangerous thing for everyone.


A version of this article first appeared in the Herald on Sunday. It is here with permission.