There is a fear that the disinflationary forces tightening their grip in the developed world are a sign of weaker global demand. The rampant decline in oil prices is at the heart of these worries and is leading to lowered expectations for when central banks in the US and the UK will start to normalise interest rates.
However, just as a good footballer will run into the space where he expects the ball to be, central banks are looking to target inflation in the future, not at today’s level.
Ultimately, the decline in energy prices is a positive for the global economy as it stems from a positive supply shock. Falling oil prices should not therefore be treated as a reliable signal of economic weakness. The reality is that oil price decline is largely being caused by an oversupply in global market, amplified by OPEC’s decision not to offset rising US production by curtailing their own. The shift in investor sentiment away from commodities has also added to oil price weakness.
Cheaper prices act as a tax cut for consumers. If the things that we buy the most frequently are getting cheaper then we are more likely to spend elsewhere. There are diminishing returns to this argument – at some point we stop spending that extra windfall and start saving a bit of it, so the boost to consumption will not last forever. But the anticipated rise in consumer spending is beginning to materialise.
In the eurozone, where inflation turned into deflation last month, retail sales increased by 1.5 per cent compared with a year ago in November. UK retail sales in November were the strongest for the past 10 years, as lower inflation pushed real wage growth into positive territory. UK inflation dropped to 0.5 per cent year-on-year in December, which was the lowest reading since 2000.
The big question remains: when will central banks start to raise rates? Low inflation does provide some room for central banks to either delay or at least reduce the pace at which interest rates are increased. But when the more volatile elements of the inflation index are stripped out, the picture is less clear. In the UK, the core rate of inflation (which excludes energy and food prices) actually ticked up slightly last month to 1.3 per cent. In the US, core inflation is also much higher than the headline number at 1.7 per cent. Central banks tend to focus on core rates as they provide a better indication of the underlying level of inflation, and hence demand, in an economy.
It is likely that both the Bank of England and the US Federal Reserve (the Fed) will look through falling oil prices and focus instead on where inflation will be about two years hence. Because inflation is a year-on-year comparison of prices, the headline number is likely to fall further in the coming months, making that core figure an increasingly important gauge. Medium-term inflation expectations, as measured by two-year breakeven inflation expectations, have shifted lower, but perhaps not enough to cause too much alarm just yet.