Price adjustments

inSight

16 Aug 2001

Price adjustments

Falling values and prices over the past three to four years have aroused as much concern as inflation once did. Which is the more worrying: rising prices or falling prices?

It was only a few years ago that we all seemed to be worried about inflation. Despite the fact that many people were happy about the rising value of their homes, the monthly consumer price statistics were typically greeted with doleful comments about the distress caused by ever rising prices in the shops, markets and restaurants. Such a reaction was understandable, and by no means unique to Hong Kong. After all, it is generally acknowledged that too rapid inflation, though it may benefit some, is an obstacle to longer-term economic growth and inflicts disproportionate pain on the poorer sections of society. As a result, the main crusade of central banks around the world for the preceding half-century had been to reduce or contain inflation.

You might therefore have thought that, having complained so much about rising prices, we would all have applauded any downward correction. Not so. The headlines which have accompanied the falling prices that Hong Kong has experienced over the past couple of years have been just as miserable.

Does this imply some intellectual inconsistency? Not necessarily. Attitudes and behaviour are driven much more by changes in prices - whether up or down - and by expectations of future changes, than by their absolute level. We don't like sharp falls any more than sharp increases (although it may be preferable to have a short dose of either rather than a prolonged one). Falling asset prices (property or shares, for example) reduce people's wealth and make them more cautious about spending, and it's worth recalling that most of the fall in the Consumer Price Index has been attributable to its property-related components. Falling prices of goods and services remove any urgency from spending plans - if you wait, it may be cheaper next month. Homeowners find themselves in "negative equity". Banks find that the collateral which they are holding against loans is depreciating. Businesses find that real assets are worth less and cash flow may be slowing, but debts remain the same (even though the interest cost of serving them may fall). These various forces combine so that in times of falling prices the economy tends to lose momentum and the "feel good" factor remains elusive.

The international consensus nowadays is that a stable, low, positive rate of inflation of around 2% per annum (but with some latitude depending on the structure of the economy and the way in which inflation is measured) may be ideal. This would avoid the depressant impact of falling prices outlined above. It also allows for interest rates to fall below the rate of inflation and hence to be negative in real terms, which is regarded as a useful tool in many policy regimes. And it allows for realistic shifts in relative prices between different products to be achieved without actual price cuts (which are seen as difficult to effect in some economies - though evidently not in Hong Kong).

For Hong Kong, with the exchange rate fixed through the Currency Board system, it is not possible to steer the underlying rate of inflation. But to the extent that price deflation is required in order to correct external competitiveness, Hong Kong has demonstrated that it is capable of effecting the adjustment through market forces quite quickly. Those economies where currency depreciation rather than internal price deflation is the accepted means of improving external competitiveness may be no better off at the end of the day.

However, whatever the route of external adjustment, it is difficult to restore the "feel good" factor decisively when the rest of the world is experiencing the combination of recession and uncertainty which it is today.

It's perhaps worth making the point that price deflation is not unequivocally damaging. If you are on a fixed income, or have put your savings in the bank rather than invested them in property, you may be quietly content with stable or falling prices. Even if the interest rate on your savings has fallen, the purchasing power of the savings is no longer being eroded by inflation. You may also be smiling if you are in business and discover that your input costs are falling faster than the prices at which your output is selling.

As with most of life's situations, there are winners as well as losers. But, generally speaking, misery makes for better headlines than does contentment.

Tony Latter
Deputy Chief Executive
16 August 2001

Statistics on Hong Kong price indices can be found here.

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Last revision date : 16 August 2001