Falling factory prices raise deflation threat

The inflationary firestorm that has raged for months is fast being extinguished. This morning's official producer prices figures provide further confirmation — if any were needed — that the chill winds of recession are dousing the inflationary flames with startling rapidity.

As a matter of simple arithmetic, it was always going to be the case that inflation would fall back pretty sharply from around now, and well into next year. To keep rising at the record rates we have seen would have required the previous surge in the cost of food and fuel not only to have continued, but also to accelerate. Given the scale of the previous increases, that looked like a pretty unlikely scenario.

But, added to this, inflation is now being quelled yet faster as the impact of a rapidly deepening recession across the West's leading economies sees demand collapse. Moreover, price pressures are being eradicated by the sharp retreat in the growth of the supply of money induced by the credit crisis. It seems unlikely that there will be much let up in this process for all or most of next year, so inflation is going to drop like a stone. Indeed, the spectre suddenly haunting policymakers on both sides of the Atlantic is not of inflation but of Japanese-style deflation.

For now, then, the present, severe economic crisis decisively removes the dilemma that central banks have faced for more than a year as they have battled to reconcile the conflicting pressures of rising price pressures and faltering growth. There is only one war to fight now — and that is the campaign to prevent recession mutating into a calamitous combination of deflation and economic depression. Inflation will no doubt return but for now policymakers must fight the present war, and not the next.

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