23rd February 2015


We have been feeling its effects for some time

With inflation falling to an all-time low there is now a concern about deflation; where prices fall rather than rise. The fear is that individuals will hold back on purchases in the expectation of getting it cheaper. However the low interest rates we have been experiencing of the last few years may have been having the same result.

The general view of money lending is that the lender makes a loan with interest attached to cover any inflation and provide a reward for the risk of default. The borrower on the other hand will balance the cost of money and potential profit and decide if the loan is viable. From this we get the convention that higher interest rates lead to a reduction in borrowing and a reduction leads to an increase in borrowing. This generally holds true whilst interest rates are greater than the rate of inflation but the dynamic changes if inflation rises above the interest paid. For the borrower the incentives are the same as above but for the lender the interest rate neither covers inflation nor provides a reward for the risk involved. In this situation the least risky option for a lender is not to lend. As much of the lending is made by banks this is not an option as they only make a profit from interest so the next least risky option is lending that buys into a business or asset that is already making returns. And this is the pattern that has developed since central banks have slashed their rates following the financial crash of 2008/9. Overall bank lending to non-financial companies has continued to fall (see Bank of England series LPMBC57) whilst assets, both property and shares, have held or risen in value. Of course the base rate is a minimum and lenders may charge a rate that is above inflation but it does have affect that is borne out by the fall in the cost of mortgages.

The irony is that with inflation hitting this new low it has fallen below that of interest rates the conventional rules come back into play. The Eurozone is suffering from deflation and the return to rates higher than inflation may have played a part in its recent recovery.

The fear of many economists is that deflation may become the norm. This is unlikely in the UK because the causes are lower food and oil prices. As essentials it is unlikely that very few people will hold back from buying them and there appears to be no reduction in the prices of big ticket items yet. So deflation should not be us for long however this may not be the case in the Eurozone. In both case the low interest rates are not only leading to a reduction in investments but is limiting the creation of new money to fuel any growth; a theme explored elsewhere on this website.

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