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Is there Deflation in South-Africa?

Sunday, March 22nd, 2015

The oil price surprise

The price of oil has fallen rapidly from its mid-2014 highs of $115 per barrel to just below $50 per barrel in January 2015. This dramatic 60% drop has rocked global markets, leaving in its wake a slew of relative winners (oil consumers) and losers (oil producers). The fall in the oil price has also raised expectations of deflation, a general decline in prices. Indeed, CPI inflation in many countries, including South Africa, has fallen quite sharply in recent months. In South Africa, official CPI inflation in December was 5,3 y/y, down from its recent high of 6,6% in May 2014. Most analysts expect CPI inflation to fall to the lower half of the Reserve Bank’s 3–6% inflation target range in the course of the first half of 2015. The consumer price index has remained effectively unchanged since August 2014 and it declined in December.

These developments have led to two important common assertions. The first is that South Africa is now experiencing deflation. The second is that deflation is bad for the economy and must be fought by the central bank through interest rate cuts.

Is South Africa experiencing deflation?

The CPI basket as measured by Statistics SA certainly indicates that, on average, consumer prices are stable or falling. A big part of that fact is the statistical influence of fuel prices in the CPI basket. Including February’s decline, the petrol price has fallen by 29%. The immediate effect of this substantial drop in the fuel price (fuel price deflation) is for the CPI to fall considerably, but, aside from this statistical impact on a hypothetical basket of consumer goods, is a lower fuel price in itself deflation? The answer is no. Price deflation can only arise in three ways: falling money supply, rising money demand, and economic progress.

Once a certain money supply is available in the monetary system it is very difficult for it to be destroyed. Practically, the only way to shrink the money supply is for commercial banks to call in loans, i.e. let loans be repaid and not extend new loans. The falling money supply scenario is very remote in the current banking system and is certainly not happening currently. South Africa does thus not have a falling money supply.

A clamour for cash, or rising money demand, can cause deflation. People might sell their stock portfolios to become cash-liquid, or they might sell their second house or have a garage sale. The supply of goods offered for sale on the market rises in relation to the money supply. This is almost always driven by a wave of fear and a loss of confidence sweeping through an economy during times of financial panic or recession. Strong money demand has likely been a feature of the South African economy since 2009 as the middle class has struggled to maintain healthy cash flows from ordinary employment and business channels.

The final kind of widespread general deflation is very different from these. It is the result of savings-funded economic progress which results in an increase in the supply and choice of goods and services. This kind of deflation took place in the 1800s in the major industrial economies of the day – Britain, United States and European countries.

There is no other cause of general deflation. Falling oil prices are not general deflation, and even falling CPI may not be reflective of general deflation. These things may or may not occur during general deflation, but they are not themselves evidence of general deflation.

In South Africa, the money supply has not contracted but instead has continued to rise by around 8% y/y for the past few years. Meanwhile the likelihood of productivity-driven deflation is low since South Africa’s economic output growth has been extremely weak by historical standards with no discernible increase in savings rates. One possibility is the rise in cash demand due to economic difficulties and uncertainty among people about their economic future. However, the exchange rate of the rand vs other major currencies over the past four years suggests that demand for rand is not terribly strong by historical standards.

On balance therefore, we find it unlikely that South Africa is experiencing or about to experience general deflation. While lower oil prices may cause CPI inflation to decline mechanically, it also frees up income to be spent on other things, which could begin to place some upward pressure on their prices.

Moreover, we should not necessarily only consider CPI to be representative of inflation or deflation. After all, inflation or deflation is really just the decrease or increase in the general purchasing power of money, and money is used to purchase far more than just the consumer goods measured by CPI. It buys company stocks, houses, land, business inputs, and foreign currencies to name just a few things. By most of these other measures, South Africans have experienced considerable inflation of late with little sign of deflation.

Is deflation bad for the economy?

No, deflation is not in itself bad for the economy. Deflation usually means prices were too high beforehand and the market is rebalancing demand and supply dynamics to achieve a more desired price level. If deflation is resulting from banks calling loans (falling money supply), then it means banks made some errors and are trying to correct those errors through more prudent business practices. If deflation arises from rising money demand, then it means people are less certain about their future and need to hold more money in the form of available cash to give them greater assurance. Falling prices during this process actually help people achieve this assurance faster and raise their quality of life since they can access more goods and services at more affordable prices. Finally, deflation from general economic progress is good by definition.

Lowering interest rates to fight deflation might ignore that the deflation is the result of economic progress, or it might retard the bank error correction process and perpetuate errors, or it might frustrate households who are actively trying to increase their purchasing power by becoming more cash-liquid. In all instances, the natural desire of the market is to achieve lower prices, and pro-inflation policies are fundamentally opposed to this market process.

Conclusion

The fall in oil prices does not by itself mean deflation will arrive. Moreover, there is little evidence of the true drivers of deflation in South Africa at present and therefore quite probable that deflation has not yet taken hold and will not for the foreseeable future. In addition, even if deflation does emerge, it would not be an economic negative since either it would be reflective of economic progress or a correction of previous mistakes as the market reallocates resources more efficiently.

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