Oran Hall | The implications of low inflation

Low and stable inflation contributes to economic stability and economic growth and is good for the general economy, businesses and individuals.

Low inflation fosters confidence and optimism. Businesses are better able to predict future costs and prices, it encourages investment and leads to improved productive capacity, it makes exports more competitive, and it encourages real savings.

Nonetheless, low inflation may be a signal of economic problems if it is associated with weaknesses in the economy and low consumer confidence, leading to low aggregate demand because of people spending less.

Inflation is the sustained increase in the general level of the prices of goods and services used by consumers or private households. The rate of inflation is the percentage change in the average price level of a fixed or representative set of goods and services - the ‘basket’ – that a typical household in an economy uses over a given period. The consumer price index, or CPI, is the main tool used to measure inflation.

The basket includes items such as food, clothing, transportation, housing, and education. All the items do not have the same importance, or weight, in the basket, as this is a function of the amount spent on each item compared to total household spending.

As such, items recording the same level of price movement will not necessarily have the same impact on inflation, because of the difference in their ‘weight’ in the basket. Additionally, because the basket of individuals differs, the impact of inflation on individual households differs. This makes low inflation more beneficial to some consumers than others.

Inflation is measured on a point-to-point basis, meaning, the CPI at one point one year is compared to the CPI at the same point the previous year. This approach evens out seasonal factors and one-off shocks. It is an ongoing method of measurement that can be used every month with a full year as an adequate time frame for reference each time.

Low inflation does not mean that prices do not increase. In fact, even when the rate of inflation declines – disinflation – prices do increase but not to the same degree as they did in a previous period.

The Bank of Jamaica, BOJ, has set a range of 4.0 per cent to 6.0 per cent per annum for inflation over the medium term for the Jamaican economy. The Federal Reserve Bank of the United States of America, by contrast, has set a target of 2.0 per cent per annum over the long term for the US.

The BOJ considers that the 4-6 per cent range is optimal to facilitate the growth and development of the Jamaican economy over the long term, and explains that the width of the target range accounts for the historical volatility of inflation in the country.

Annual inflation was estimated at 1.2 per cent in August.

Businesses, consumers and governments can reap benefits when the rate of inflation is low.

Businesses like low rates of inflation because it makes it easier to plan, because future prices and costs are more predictable. They can also be more confident of sustainable long-term growth. Low levels of inflation also facilitate lower interest rates. This helps businesses to secure cheaper loan funds for working capital and for their long-term growth and development.

Governments can also plan with more certainty for the long term, and have greater control over costs. Central banks can also design and implement effective monetary policy measures that will cause less shock to the economy, and economists are able to make growth forecasts with a greater level of certainty.

From the point of view of the individual, low inflation is important, as it makes it easier to plan, to maintain purchasing power, and to manage the cost of living. Although any level of inflation causes the purchasing power of consumers to decline, low inflation rates cause the deterioration to be at a slower pace. Consumers can also benefit from lower lending rates, to acquire meaningful assets and be better able to plan for the long term.

Low inflation is beneficial to people on fixed incomes, for example, pensioners, because it generally does not cause a steep erosion of their purchasing power.

As for the effects on investments, lower interest rates lead to lower returns on interest-bearing securities, bonds and debentures, for example. The rate of interest on savings instruments may also fall. On the other hand, stock prices often increase as some investors switch from interest-bearing instruments to equities.

Low inflation rates, while being beneficial to governments and businesses, have the potential to improve the financial position of individuals by protecting their purchasing power, making credit more manageable, and improving their ability to realise real investment returns.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. finviser.jm@gmail.com