TOUGH TIMES ON THE HORIZON

Figures out this week from both sides of the pond are looking like they will confirm that the annual rate of inflation is decelerating. This may on some measures show inflation as negative. This may sound like good news to households where incomes have been squeezed by tax rises and higher bills. But a sustained period of deflation would have huge economic costs. While the risk that deflation will take hold of the Western economies is small, the prospect is powerfully exercising the minds of central bankers and explains the urgency with which the BoE and the Fed have cut interest rates. Deflation would be the worst of outcomes for the global economy.

Unfortunately, easy monetary policy also stimulated an unsustainable boom in asset prices and an irresponsible expansion of credit. The collapse of the housing market bubble and the credit crunch are now pulling the global economy down into recession. Inflation is decelerating sharply, helped by falls in commodity prices. In the UK, the annual rate of CPI declined a full point to 3.1% in December. The BoE expects the figure to fall below 1%. Annual inflation as measured by the retail price index has been falling even more rapidly and is approaching its lowest level since 1960.

Although a short period of falling prices does little damage. Consumers will eventually become used to seeing the prices of some items fall consistently, but a long period of general price falls, as happened in Japan in the 1990s, would be damaging. Consumers would star to postpone purchases, as they would have the ability to buy goods more cheaply in the following months or years. This leads on to both employment and investment collapsing. Stocks fall as corporate earnings would contract. Most damaging, households with debt - either mortgage debt or unsecured loans - would suffer intense hardship. Adjusted for inflation, the value of their debt burden would rise. Deflation would cause hardship, eviction and widespread corporate and personal bankruptcy. This is the risk, if not yet prospect, that both central banks will now contend with

In Europe, German investor confidence (out at 11:00 GMT) is looking likely to show that it has improved for a fourth month in February after the government stepped up efforts to bolster the economy and the ECB signaled it will cut interest rates to a record low. The ZEW Center for European Economic Research is expected to say that its index of investor and analyst expectations rose to -25 from -31 in January. The index reached a record low of -3.9 in July. ECB policy makers say they have room to drop borrowing costs further as the euro area battles its worst recession since World War II. The German Chancellor, Angela Merkel, agreed to spend about €80billion over two years to boost the German economy, the largest in the 16-nation bloc. This has led to Germany’s benchmark DAX share index has rising 4% over the past three weeks.

German GDP slumped 2.1% in the fourth quarter of 2008 from the third, the biggest drop in 22 years. The economy is looking to shrink by a further 2.5% this year, according to the IMF. Porsche SE, have reported a 14% plunge in sales, and Volkswagen AG’s Audi luxury division expects a “super difficult” year.The ECB has cut its rates by 2.25% points since early October to 2%, the most aggressive easing since the bank took control of monetary policy a decade ago. This is expected to drop further to 1.5% in their March meeting.

Raphaels Bank CFX Team
0800 587 8722
cfx@raphael.co.uk
www.raphaelsbank.com/cfx

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