The next Bank of England quarterly inflationary report due tomorrow will confirm that the rate of inflation in the UK has fallen again. Don't be surprised if there are alarm bells ringing, with the report making comment on the prospect of future deflation.
Last year David Cameron initiated an aggressive series of spending cuts, declaring at the time that the impact of the cuts will require "years of pain" and "will affect our whole way of life". The Government continues to argue that such deep cuts are necessary to bring our deficits under control and restore confidence within the private sector. Implicit in the austerity program is the public spending stimulus ending and the private sector being healthy enough to take up the slack. Sadly, the private sector obviously was not healthy enough to do this in 2011. Nor is it now.
Owing to a lack of overall confidence, coupled with a continued reduction in consumer demand, the private sector is unable to rescue the UK economy. Consequently, unemployment continues to rise. The UK economy is almost certain to be in and out of recession throughout 2012 and possibly longer if the policies continue as they are.
The immediate outcome is deflation.
Deflation is a sustained decline in the price level of goods and services, which occurs when the annual inflation rate falls below zero per cent (a negative inflation rate), resulting in an increase in the real value of money.
The effect is that prices and wages fall. Consequently, the supply of money shrinks, resulting in even lower prices and wages. This creates a vicious deflationary spiral of negatives, including declining profits, closing factories, shrinking incomes and employment and a rise in loan defaults by individuals and companies.
Deflation creates a liquidity trap in the economy when lower interest rates fail to stimulate spending. The nasty cycle of declining demand and rising unemployment often leads to a depression.
Both inflation and deflation can negatively impact the economy. However, most economists consider the effects of moderate long-term inflation to be less damaging than deflation.
Given the disproportionate extent of the financial imbalance and consequently the economic policies in place, sooner or later the pendulum is very likely to swing toward economic policies that are even more inflationary than they are now. This may be necessary to counter the present deflationary threat or simply that governments will use inflation as a means to resolve their debt burden. This may be necessary if there is no growth.
The alternative is to increase the present austerity measures; this will be necessary if the austerity process is to be effective in reducing debt. Sustained austerity will be hugely unpalatable over the longer term and may lead to more civil unrest on our streets. Remember the 1973 oil crisis, the extreme 1940s-style austerity which included the three-day week? This was followed by an annual average rate of inflation of 19.5 per cent between 1974-77. One of the reasons for this was the combination of strong trade unions and consequent high pay increases that were negotiated with employers following the period of austerity.
Sooner or later the present austerity process will come to an end and after years of pay cuts and pay freezes employees in both private and public sectors will naturally want increases in their pay. When that time comes are we to expect a stable and reasonable approach to pay demands?
In my opinion it is not unthinkable to anticipate that UK inflation is actually more of a threat in the coming years than deflation. This could have a substantial change in how we approach investment strategy, albeit temporarily.
The reason for investing in real assets such as property, equity and bond sectors is to protect the buying power of capital from inflation. One of the questions we have to ask before investing in equity and bond sectors is, is it worth taking on investment risk relative to the return I can get if I remain in cash?
As it is now possible to invest in such way as to target inflation directly in practically any economy in the world, we may find that in the future the question we may then want to ask is, relative to the return I can get by directly targeting inflation, are equity and bond investments worth the risk?
Source : http://www.thisiscornwall.co.uk
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