InTheKnow: Deflation

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on June 8, 2020 - June 14, 2020.
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What is it?

Deflation refers to a general and widespread decline in the prices of goods and services in an economy. There have been recent concerns about a deflationary trend in Malaysia as the country reported two consecutive months of declining growth in the Consumer Price Index (CPI).

It was reported that the country’s CPI fell 2.9% in April 2020 — the sharpest year-on-year (y-o-y) drop in 10 years. This was the second month in a row that the CPI had been in decline, after a 0.2% drop in March. The CPI is a measure of the prices of a basket of goods and services consumed by an average household throughout the economy. The percentage movement on this index over time is taken as a measure of headline inflation, or in this case, deflation.

In general, this basket often includes items such as essential groceries, transport, utilities, as well as medical costs.

According to the Department of Statistics Malaysia (DOSM), the 2.9% decline in the country was attributed to the drop in prices of transport, housing, water, electricity and fuel.

 

 

Its effects

When deflation happens, it tends to have a positive, albeit temporary, effect on consumers. According to Dr Yeah Kim Leng, professor of economics at Sunway University Business School, deflation improves individuals’ purchasing power. Ordinarily, this increase in purchasing power would result in increased demand, thus forcing prices upwards again. The Covid-19 outbreak, however, has significantly affected this dynamic.

Due to the pandemic-induced economic shutdown, there are increased fears around job prospects, employment status and wage reduction — factors that Yeah says will negatively impact demand.

The longer the economy operates below full capacity, even under the improved conditions of the present Conditional MCO, the more consumer sentiment will deteriorate, says Yeah. Worsening sentiment will gradually impair demand, and past a certain point, deflation would be driven by a general lack of consumer demand.

Deflation brought about by a lack of consumer demand would be the worst-case scenario for any economy, says Yeah. It signals a lack of confidence in the economy, as people prefer holding on to money rather than spending it. This, he says, is unlikely to happen in Malaysia.

“Such a signal would prompt businesses to drastically scale back on economic activity and put expansion plans on hold. This, in turn, would further shrink an already ailing economy. Businesses would have to liquidate the excess inventory and, eventually, conduct mass lay-offs. At this point, a self-perpetuating cycle would have set in: Persistent deflation would now force an already-shrinking economy to contract further.

“Six to twelve consecutive months of deflation would be the clearest indication that the overall economy is on a downward spiral and headed for a sharp contraction,” says Yeah.

 

 

What causes it?

In general, deflation can have a variety of causes. According to Investopedia, these include a shortage of money in circulation, leading to an increase in the value of money, thereby reducing prices.

Also, an oversupply of goods in the market would force businesses to decrease prices to induce consumers to purchase those goods. Thirdly, there might not be enough money in circulation, to the point that those with money hold on to it, rather than spend it.

Finally, there might be an overall decrease in consumer demand for goods, and therefore, spending drops, leading to a widespread reduction in prices.

That said, Malaysia’s negative CPI growth in April was not primarily caused by a widespread drop in demand among consumers. Rather, it was caused by the drastic fall in the cost of transport, on the back of depressed global oil prices.

Falling crude oil prices from earlier this year were a major contributor to deflation, more so than the economic shutdown, according to Yeah. In fact, prices in the transport component of the CPI fell 21.5% y-o-y.

This was due to the Russia-Saudi Arabia oil price war, which started on March 8, just 10 days before Malaysia’s first Movement Control Order (MCO) was imposed. The oil price war resulted in a sharp contraction in crude oil prices. Malaysia’s CPI is heavily influenced by transport — Yeah says it is the third-largest component, making up 14.6% of the basket of goods and services.

“Fuel is a major input cost to the transport industry. Therefore, a crash in the price of crude oil results in a significant drop in costs to the transport industry. Given the outsized influence that transport has on the Malaysian CPI, this was the primary driver of the negative April CPI reading.”

 

 

The outlook for Malaysia

While there is a deflationary trend in Malaysia, Yeah says currently it is not systemic within the economy, despite two consecutive months of falling headline CPI. He does not expect deflation to last long, nor does he anticipate falling consumer demand to become a persistent problem.

It is unlikely that Malaysia will experience more than six consecutive months of deflation, he notes. This is because generally, Southeast Asian economies tend to have higher growth trajectories than their European and American counterparts. Therefore, countries such as Malaysia would not be expected to suffer from stalled demand for too long.

“In addition to close geographical and trade links to the world’s two most populous countries, China and India, Southeast Asian economies are relatively open and market-driven. With rising consumption powered by an increasingly affluent middle class and rising attractiveness to international investors, the region’s growth trajectory is set to resume in the post-Covid-19 environment at a more modest but still high 4% to 5% per annum,” Yeah says.

Going forward, he also believes the government is going to take a localised approach to future Covid-19 clusters, rather than impose blanket shutdowns of the economy. This would serve to bolster consumer demand, thereby gradually reversing deflation.

“Instead of shutting down the entire economy, I believe the government prefers to impose Enhanced MCOs on specific areas where clusters are known to [exist]. The rest of the economy will be permitted, as far as possible, to gradually reopen, with strict detection and social distancing protocols in place.”

Yeah has forecast a 2020 CPI range of between -1% and 1%, Meanwhile, Bank Negara Malaysia in early April forecast headline inflation for this year to be between -1.5% and 0.5%.

 

 Dr Yeah Kim Leng, theedgemarkets.com, Department of Statistics Malaysia, Bank Negara Malaysia and Investopedia