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Sunday, March 23, 2003

BoE Paper Gives Thumbs Down to British Deflation

According to the latest paper to come out of the Bank of England, deflation is unlikely to be a major problem in the UK. Unless, of course, there's a housing crash. We'll see.

A general price deflation in which interest rates fall to zero is 'highly unlikely' to hit Britain, according to a paper published by the Bank of England today. Interest rates at historically low levels around the world and a troubled economic outlook have prompted central banks to start worrying about deflation. Japan, where prices are falling and the economy is stagnating even though the Bank of Japan has, in effect, cut rates to zero, is an example nobody wants to follow. But an article by one of the Bank of England's economists in its latest quarterly bulletin says economic models suggest that for an economy such as Britain's, which is aiming for an inflation target of 2.5 per cent, the risk of a deflationary spiral is "very small indeed". In part that is because if the Bank saw a risk of deflation it could, and would, cut interest rates aggressively to head off the threat.

However, the article also argues that central banks should in normal times try to move interest rates only gradually, to reassure the markets that any change was likely to stick. If the preventive policy fails and deflation does persist, and interest rates have been cut to zero, the Bank paper considers possible policies for breaking out of the trap. Such policies would include tax and spending decisions, buying shares or bonds, devaluing the exchange rate and printing money to pay for a tax cut. But it concludes that many of these policies are "untried and untested", and prevention is likely to be better than cure. With underlying inflation at 3 per cent, and expected to go higher, deflation seems like the least of the Bank's problems. A house price crash, likely to be accompanied by a slump in consumer demand, could resurrect deflation as a significant threat.
Source: Financial Times

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