How do we deal with deflation?

It looks very much like deflation is becoming the new normal for many Asian countries during the ongoing recession brought by the Covid-19 pandemic.

The Malaysian consumer price index (CPI) figures for May showed prices falling by 2.9% year-on-year for the second month running. Thailand, Taiwan, South Korea and Singapore are also in deflation with consumer prices falling year-on-year by 3.4%, 1.2%, 0.3% and 0.8% respectively.

Wider deflation indicators are also emerging. Producer prices fell in Malaysia by 5.1% in April and by 2.7% in Japan and 3.7% in China during May. Wholesale prices in May fell by 11.6% in Taiwan and 3.2% in India. So it appears that there is an underlying deflationary trend across a large part of Asia, taking consumer, producer and commodity prices together.

These are unusual economic conditions and raise questions about the risks of deflation and the type of policies necessary to restore price stability or inflation around 2%.

Deflation is usually taken to mean the process of generally falling prices which raises the purchasing power of money. It is the opposite of inflation and sometimes called negative inflation.

The most common explanation for deflation focuses on weak demand when, for example, low consumer spending causes firms to cut prices across the board.

If consumers see prices falling they may hold back on spending and wait for prices to fall even further. This leads to a downward spiral in spending and, eventually, firms begin to cut salaries or sack workers, which reduces spending even further.

This standard economic explanation goes only part of the way in explaining the current deflation, particularly here in Malaysia, because consumer spending before the lockdown was buoyant.

The unique feature of the Covid-recession is that, for the first time in history, we see a strong, deliberate and coordinated policy shock to both the domestic and international economies due to the forced closure of businesses which physically prevented people from taking part in all but essential economic activities.

For Malaysia, the damaging effects of the Covid-lockdown are beginning to be seen in the early inflation data from the lockdown period. Headline CPI inflation is negative and will remain so until the end of the year.

Core inflation is positive but shows signs of weakness, falling to 1.1% year-on-year in May compared to 1.3% year-on-year in April and is very likely to continue on a downtrend.

The decrease in the headline CPI was driven by a 20.8% fall in the price of transportation, largely due to lower petrol prices compared to last year.

The cost of housing, water, electricity, gas and other fuels fell by 2.6% due to various government incentives in the Prihatin and Penjana programmes to ease the burden of the Covid-lockdown.

Prices of clothing and footwear fell by 1.1% and prices of furnishings, household equipment and routine household maintenance fell by 0.2% due to discounting from cash-strapped retailers. Together, these four categories contributed 45.7% to overall CPI.

Many analysts have argued that the impact of oil prices reduces the risk of a prolonged deflation because as oil prices recover the CPI will rise.

This view may prove too optimistic because although the fall in oil prices began before the pandemic, the collapse in global demand for oil due to Covid lockdowns worldwide has kept oil and petrol prices subdued.

Excluding petrol prices, inflation in Malaysia is only around 0.1% and teetering on the edge of deflation even taking low oil prices into account.

So the nature of the deflation we are experiencing in Malaysia today is largely a result of the movement control order (MCO) or the Covid-lockdown rather than other causes.

Of additional concern is the effect of the lockdown on wages and employment and the backdrop of weak salaries and wages which fell 11.5% in March.

Unemployment rose to 5% in June, the highest rate for 30 years. Together, these factors suppress disposable income and drag down consumption.

This is a direct effect of the MCO and may force deflation to broaden across price categories in the coming months because once the wage subsidies and employment retention components of the Prihatin and Penjana programmes end, there is likely to be considerable retrenchment and wage cuts across the board.

Taken together, these negative effects will hit expectations hard and cause extreme caution among consumers, businesses and investors which will hold back any expected upturn in demand and might push us into full-blown deflation and depression.

In the current circumstances where the deficit and debt levels are becoming a constraint, avoiding deflation cannot be solved without a mix of fiscal and monetary policy.

In our view, an additional cash injection of RM50 billion is needed. This will give a sufficient positive push to the system. It will also have a positive reset effect on expectations and set a new expansion path for the economy.

The government can finance this by issuing new long-term bonds but it would be prudent for Bank Negara to act as a buyer of last resort to absorb any residual amount not taken by the market, as is currently the policy of the Bank of England.

In addition, Bank Negara can adopt a target of zero real interest rates using core inflation. This would allow an additional cut of 75 basis points in the OPR and may even reduce the yield of the 10-year bond, currently the highest in Asia at 2.88%, which is restricting investment and durable goods sales.

Malaysia is in a deflationary cycle that is likely to persist at least to the end of 2020 and possibly beyond. The cause is largely due to the MCO and the impact on consumer demand.

Even taking lower petrol prices into account, Malaysia is teetering on the edge of prolonged deflation which may push us into a depression. Only coordinated action between the government and the central bank can redirect the economy and put it on the right expansion direction.

Geoffrey Williams, Paolo Casadio and Hui Hon Chung are economists at HELP University based in Kuala Lumpur. The views expressed here are their own. - FMT