Deflation spiral risks Depression repeat
John Kehoe

The coronavirus recession and oil price crash could push inflation below zero for the first time since the Great Depression, causing a dangerous deflation spiral that will require a huge government spending stimulus after the virus passes, a former top Treasury economist has warned.

Canberra-based Outlook Economics director Peter Downes said because the Reserve Bank of Australia will not cut the cash rate below the current 0.25 per cent, real interest rates — which are adjusted for inflation — will rise and hurt the economic recovery.

The government would ultimately need to step in and inject another huge fiscal stimulus on top of the $84 billion announced so far, he said.

Rising unemployment, weak wage growth and the oil price collapse to below $US30 a barrel after negotiations broke down between Russia and the Organisation of the Petroleum Exporting Countries will push inflation to or below zero by the middle of next year, according to his preliminary economic modelling.

Australia is at risk of deflation. AFR

That is despite a likely short-term price spike in some grocery items due to panic buying.

Inflation below zero

“Once you throw in the low oil prices with unemployment rising you get a disinflation dynamic developing,” said Mr Downes, a former top forecaster at Treasury and the Organisation for Economic Co-operation and Development.

“I’m getting inflation dropping below zero towards the end of 2020-21.”

Economists believe deflation is dangerous because it can suppress wage growth and encourage consumers to delay spending and investors to defer asset purchases if they believe prices will be cheaper in the future.

Disinflation (slowing price growth) and deflation (falling prices) also make it harder to repay debts incurred in better economic times.

Falling prices exacerbated the Great Depression in the 1930s which was caused by the collapse of banks and tight monetary policy.

RBA out of bullets

To support the economy in response to the 2008-09 global financial crisis, the RBA slashed the official overnight cash rate by 4.25 percentage points to 3 per cent.

But with no capacity to further cut the cash rate and the RBA deploying unconventional bond buying and cheap bank funding to drive down longer-term borrowing costs, the central bank will not be able to repeat its GFC emergency moves.

“If inflation falls from 2 per cent to zero, that means real interest rates have risen by 2 percentage points,” Mr Downes said.

“A normal monetary policy response to a crisis like this would be an aggressive 400 basis point reduction in the RBA cash rate.

“But we could have the opposite with an increase in real interest rates which would truncate the recovery.”

Mr Downes said for every 1 percentage point of rate cuts the RBA would have done, the government would need to spend about $20 billion, or 1 per cent of GDP.

“As we come out the other side of this we will probably require a very large fiscal stimulus on top of what’s already been done.”

“If inflation is falling and real interest rates are rising the fiscal package will potentially have to be very large and also very well designed.”

He said the government’s first $17.6 billion and second $66 billion fiscal support packages were good, but “not large enough to offset the huge shock” that will cause unemployment to rise.

“Things are going to get a lot worse before they get better,” Mr Downes said.

Annual inflation was a subdued 1.8 per cent in the December quarter, below the RBA’s 2-3 per cent target band.

RBA governor Philip Lowe has blamed weak inflation and wage growth on global trends such as an excess of savings by an ageing population, and competition from technology and globalisation.

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John Kehoe writes on economics, politics and business from the Canberra press gallery. He is a former Washington correspondent. Connect with John on Twitter. Email John at jkehoe@afr.com

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