Deflation is not an economic term which has tripped off the tongue in the last three decades. Far from it. A series of political crises in the Middle East, starting with the six-day war in 1967, triggered 30 years of almost continuous inflation, fuelled by surging oil and commodity prices and then absorbed by the west's over-accommodating credit policies and profligate expansion of budget deficits.

However, as the world looks to the rest of this year and the next, there is an increasing consensus among economists and policymakers that deflation could be the next enemy. For the US, in particular, it is an especially troubling spectre. In much the same way as the inflation of the Weimar Republic in the 1920s and early 1930s sparked the permanent fear of hyper-inflation in modern Germany, so the deflation of the 1930s in the US - when more than 25 per cent of the workforce was without jobs - has shaped American economic policy for most of this century. While disinflation - a slowdown in the level of inflation - may over the short-term seem desirable, even advantageous to some businesses, in the longer term it can be disastrous.

Among the more obvious early indicators of inflation are commodity prices. No air carrier can have failed to miss this trend. After Saddam Hussein's tanks rolled into Kuwait in August 1990 and threatened Saudi Arabia too, the price of benchmark Brent crude oil surged to US$60 per barrel. In January 1998, as demand from the heavy oil burning economies of the Asia-Pacific region collapsed, oil was trading at $16 a barrel - an immediate cost benefit for the airline industry.

Oil prices have not been the only commodity on a downward path. Gold, regarded as a forward indicator of inflationary expectations, stood at $1,000 an ounce in 1980, soon after the Iranian revolution and then US president Jimmy Carter's fight against an energy-induced inflation crisis which sorely damaged the dollar. At the start of this year gold was trading at $232 an ounce - its lowest level since the remnants of the gold standard were dismantled by president Nixon in 1973. In fact the price of many metals, including copper, has been falling steadily, touching its lowest level in four years in January. In the years leading up to the Great Depression of the 1930s metal prices slumped 40 per cent as industrial production contracted.

The debate about the new deflation was largely sparked by the chairman of the US Federal Reserve Board, Alan Greenspan. He told the American Economic Association at the start of this year that 'inflation has become so low that policymakers need to consider at what point effective price stability has been reached'. In other words, at some point a rapid decline in asset prices, like shares and land values, increases the risk of a financial catastrophe and jeopardises economic activity.

The current crisis in Asia is one of the reasons the deflation alarm bells are beginning to sound. Why does deflation matter? Largely because it redistributes wealth from debtors to creditors and can lead to severe cash flow and solvency problems for debtors who are locked into fixed contracts. Moreover, it increases the real value of outstanding government debt, threatening its sustainability and risking a further tightening of budgets which can deepen a downturn.

Under normal circumstances it might be possible to tackle deflation, as was done in the 1930s, by increasing government spending on work projects and other devices. However, as economists at Banque Paribas have pointed out, at present that is not possible because the debt to gross domestic product ratio among the largest seven industrial economies already stands at 70 per cent, giving little safe scope for expansion.

There are a number of other reasons to believe that the odds are swinging towards deflation. The Asian crisis, which has produced sharp devaluations in many of the countries concerned, almost certainly means that goods exported to western economies this year and next are going to be much lower in price. This comes on top of the lowest US inflation rate in 31 years, with wholesale prices down in 1997 by 1.2 per cent and a US stock market which looks vulnerable to correction. Moreover, across the west the gradual elimination of agricultural subsidies is leading to declining land prices, another typical deflation symptom.

If budgetary policy cannot be used to tackle deflation (partly because of the rules imposed in Europe by the introduction of the single currency) interest rates must be used instead. The current trend in commodity prices, producer prices and the effects of the Asian meltdown would apparently suggest that in most western countries interest rates could be held or cut without posing any risks. Greenspan clearly believes this is the case in the US, where he has shifted away from his warnings of late 1996 about 'over-exuberance' in the markets. Even the German Bundesbank hinted at its first meeting of 1998 that, given the developing circumstances in the world economy, lower growth estimates and the problems of Asia, it was not looking to any further rises in interest rates.

In the UK, where interest rates are currently higher than in any other G7 country largely as a result of its inflation history, the markets have begun to signal lower sterling interest rates. The only G7 economy where rates cannot really be reduced and fiscal policy would have to be used is Japan, which is at the core of the current Asian problem.

Over the short run, this all looks manageable for western businesses, including airlines, which should benefit from lower oil prices, cheaper components for their equipment, lower costs generally and a decline in financing costs as interest rates turn downwards. The risk is that the corrective action in terms of lower interest rates and budget expansions in the west will prove insufficient to turn around an adverse situation: it will then once again be a case of battening down the hatches.

Alex Brummer

Source: Airline Business