Deflation (May 2015)

Deflation

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This week, the Bank of England announced that inflation is now negative – this is known as deflation – for the first time since the early 1960s. This means that buying basic goods is getting cheaper rather than more expensive. This is good right? It means we all save some money? Let’s have a look.

Firstly, what has caused this deflation? Inflation is often driven by the price of oil. So much of both manufacturing and our every day lives are dependent on fuel, that a change in oil prices affects everything. If oil goes down in price, almost everything else does too. In the last six months, crude oil has halved in price.

So, what has caused this? Why has oil, a commodity which cannot be made but only extracted and refined, suddenly become cheaper? Oil is produced by very few countries and many of them are in the middle East, including Saudi Arabia. Now, Saudi Arabia has deliberately increased the amount of oil it is extracting and selling. The oil markets are like any other market (see the article on the Swiss peg). If there is lots of oil, then the price goes down.

Why though, would Saudi Arabia increase their supply? They have halved their income from $100 per barrel to $50 per barrel. Why would they do that? Good question! No one actually knows (apart from the Saudis I guess.) However, there has been lots of speculation and there are two different likely reasons:

Possible Reason 1: Due to oil prices being so high, people had become very inventive at finding ways to not buy oil from Saudi Arabia. They started trying to find their own oil. One method is through fracking, removing oil from shale (in your own country). Fracking is expensive but if it is cheaper than buying oil from Saudi Arabia, then it is worth doing (unless you live above where they decide to it of course!)

Now, Saudi Arabia sells a lot of oil to the US, they are not happy that the US is becoming self-sufficient with its oil production. If therefore, Saudi Arabia reduces the price of oil, just for a little while, just until all the new fracking companies go out of business, then in the long term, it will be better off. They can then raise the price again, having bankrupted all their competitors. Is this why they have increased production? Not good for the US frackers (I need to be very careful how I write that word!)

Possible Reason 2: Depending on your political/religious viewpoint, some of the dodgiest regimes in the world are completely dependent on selling oil. (Places like Russia and Iran.) The most effective way to defeat a regime is thought to be economic – people who cannot have what they want to have are generally dissatisfied, dissatisfied people try to change their government. Up until now, sanctions against these countries have been less than effective because they both have oil. That oil is now worth less (because Saudi Arabia has flooded the market, so to speak.) This will put a lot of pressure on those regimes. The US will like that, so maybe Saudi Arabia is acting in unison with the US.

Let’s go back to the original question, is deflation good or bad? Governments, on the whole, do not like deflation, they think it is bad for the economy. If everyone is spending, moving money around, that is good for the economy. If companies are investing (buying new equipment) then that too is good for the economy. However, if people see prices coming down, if they know that if they wait for a month, that new television will probably cost less, then they delay spending money. Delayed spending means less money moving around, which is bad for the economy. Therefore governments like to have low inflation. Now, this present deflation is probably going to be fairly short in duration and will not plummet too far, so it will make very little difference. It is an interesting occurrence though and shows what a completely connected world we live in.

 

 

A financial article is posted every Saturday.

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