Plunging oil prices late last year and a weak global economy have caused the shadow of deflation to loom large over many developed economies.
But in recent months, it seems the clouds may be clearing. Signs of price pressures picking up in recent months have prompted some market watchers to suggest that deflation is no longer a global threat.
At first blush, deflation - the phenomenon of declining consumer prices across the economy - seems like a friendly creature. It comes across first as falling prices or negative inflation. But if it persists, it has the potential to turn sinister.
It is generally accepted that lower consumer prices spur economic growth, but this "good" deflation holds only if people expect prices to start rising again in the future.
The problems come when nominal incomes fall, asset prices keep declining or when expectations of falling prices become ingrained.
If prices keep dropping over a sustained period of time, economic activity can screech to a halt. Households hold off making purchases as they anticipate further price declines; companies postpone investment and hiring as they are forced to cut prices. A deflationary spiral is born.
Deflation fuelled two of the worst economic disasters in modern times - the Great Depression of the 1930s, and the less catastrophic but more recent experience of Japan's "lost decades" with almost no economic growth.
When oil prices plunged in October last year, there were worries that economies would once again sink into deflationary spirals fuelled by tepid global growth and lacklustre demand.
For instance, inflation in the 18 countries that share the euro slowed to just 0.3 per cent last November, from 0.4 per cent the previous month.
Some economists say recent events point to a rosier outlook. But is the developed world free of the spectre of deflation?
Nascent signs of recovery
Several countries in the region have been reporting negative inflation rates, including Singapore which had reported a negative inflation rate of 0.3 per cent last November, the first time in five years. The previous negative inflation recording had been in December 2009, amid the global financial crisis.
But economists do not view Singapore's low or negative rates of headline inflation in recent months as a cause for concern, as they were due not only to cheaper crude but also deliberate government policies to cool the car and housing markets.
Deflation is usually associated with broad-based and persistent declines in consumer prices across the economy, which is not happening in Singapore.
Price deflation also typically takes hold against a broader macro-economic backdrop of very weak aggregate demand.
In Singapore's case, however, the economy is still expanding at a moderate pace and wages are still rising.
At the moment, the negative inflation readings reported in the region are likely to be "good" deflation, generated largely by the plunge in global oil prices, said Christine Shields, consultant economist at Oxford Economics, in a research note.
In fact, global oil prices already appear to be staging a recovery, having risen by about 40 per cent since January. Brent crude has gone up from a low of US$46 per barrel in January to about US$67 per barrel.
This has already fed through to higher retail prices for fuel in some countries.
There are also nascent signs that price pressures are building up in developed economies as they gradually recover.
Richard Jerram, chief economist at the Bank of Singapore, said in a research note that deflationary pressure on the world economy is fading as a result of higher oil prices, more aggressive policy, and a rebound in growth.
In the euro zone, where deflation risks have been a major concern, the fall in the euro has helped to lift prices and the economic outlook appears to be tentatively recovering.
Just the fact that markets are discussing the possibility that the European Central Bank might start to cut back on its quantitative easing programme "tells us how much progress they have made in the fight against deflation in recent months", Jerram noted.
Meanwhile, the United States economy had a poor start to the year, but economists believe much of that weakness was down to bad weather.
The US labour market snapped back from the brutal winter with a return to healthy job growth last month, fuelling optimism about a gradual recovery in the world's largest economy.
These signs seem to suggest that current low or negative rates of inflation are a temporary phenomenon which should fade as oil prices recover and the global economy gradually emerges from its post-financial crisis demand slump.
Demographics and deflation
While it appears that the threat of deflation has been averted, for now, it is probably too soon to sound the all-clear.
It is true that deflation is unlikely to become ingrained in the US or Britain, where the unemployment rate has been falling steadily and the economy is gradually recovering, said Andrew Kenningham, senior global economist for London-based Capital Economics. However, "the threat of a prolonged period of exceptionally low inflation or outright deflation in much of Europe and in Japan remains very real".
The boost to demand in the euro zone resulting from the depreciation of the euro and the fall in oil prices is likely to prove short-lived, while policymakers in Japan are still struggling to lift inflation rates in the country, he added.
Confidence in the so-called Abenomics stimulus policies - including significant government spending and massive central bank monetary easing - is also waning as economic growth in Japan remains stubbornly below par.
There are also longer-term concerns which might cause deflation to persist, particularly in Asia.
Demographic trends are changing rapidly in several Asian countries and might exacerbate deflation in the long run, noted Bank of America Merrill Lynch economist Chua Hak Bin. An ageing society implies a shrinking workforce and slowing long-term economic growth.
Experiences in Japan and Europe - where working-age population growth has turned negative - point to troubling trends, including lower potential growth rates, a rising fiscal burden and deflationary pressures, he added.
As ageing gains pace in the coming decade for places such as South Korea, Thailand, Taiwan, Singapore and Hong Kong, deflationary pressures could have a growing impact on policy.
"Japan's experience is not to be lightly dismissed as an exception," said Dr Chua.
Other than Japan, China may be the Asian economy at highest risk of sinking into deflation, said Oxford Economics' Shields.
That is a worrying prospect with tremendous implications for the global economy and particularly for Asia, for whom China is a key growth engine.
There are already signs that the economy in China, the world's second-largest economy, is deteriorating.
A cooling property market and slackening growth in manufacturing and investment have weighed on the Chinese economy. Annual growth is widely forecast to sag to 7 per cent this year, down from 7.4 per cent last year.
Domestic demand growth is slowing, especially in the real estate sector. At the same time, property prices and the prices of many manufactured goods were already falling before the plunge in global oil prices, Shields noted.
In addition, China's working-age population will start falling next year, according to United Nations estimates, with the "one child" policy accelerating its demographic transition.
The People's Bank of China cut interest rates for the third time in six months earlier this month in a bid to lower companies' borrowing costs and stoke a sputtering economy that is headed for its worst year in a quarter of a century.
China's ageing and deflationary cycle will have far-reaching consequences for the world because of its sheer size, Dr Chua said.
Its slowdown has already led to a collapse in commodity prices, which set off global deflationary pressures.
The anticipated oil price recovery is expected to lift some economies out of negative inflation.
But those already at risk of deflation before the oil price slump remain at risk.
This means that a shock that intensifies the slowdown in domestic demand and depresses long-term growth expectations could be detrimental for the region.
Unlike in the West or Japan, however, most Asian central banks still have a range of conventional monetary policy tools at their disposal to cope with a genuine threat of prolonged price deflation or in reaction to financial shocks - for instance, lowering interest rates.
The discussion about global deflation has also brought Asia's demographic transition into starker focus.
With the region's elderly population set to grow dramatically in the coming years, managing the associated challenges - including slower growth and potential deflation - should be a top policymaking priority.
Chia Yan Min
The Straits Times
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