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Industry airs its fears over deflationary talk

Concerns of a deflationary market have prompted some fund managers to issue strong statements to the contrary.

Seemingly fearing that talk of deflation could prove to be a self-fulfilling prophecy, the fund managers – joined last week by Baring Asset Management and Schroders – have stressed they do not believe that Britain is in danger.

Although the price of manufacturing goods is falling, Baring says it is a trend that is unlikely to spread through the whole economy. Global head of fixed income Rory MacLeod says: “We do not see the UK facing any real threat from deflation. What people need to remember is that many consumer price indices in Western countries consist of service industries, many of which are seeing price increases.”

MacLeod believes there are three prerequisites to deflation. One is that the Government imposes an inappropriately tight monetary policy, mismanaging the situation in a similar way to Japan. Another is that sterling becomes highly overvalued, resulting in deflation being imported. Third would be a fall in house prices. None is likely to happen, according to MacLeod.

While many fund managers agree with his overall assessment, not all are so bullish. Schroders chief economist Keith Wade says he cannot see an immediate end to the downward pressure on prices but that, in the US and UK at least, there is no evidence that this is leading consumers to postpone purchases, as would happen if a deflationary psychology had set in.

He also points to strong demand for consumer borrowing, which he says is a sign that there is little expectation for interest rates to rise, as they would if there was widespread belief that prices would fall. Nevertheless, Wade puts the probability of deflation in 2004 at 20 per cent, which he concedes represents a significant risk.

Many IFAs warn against complacency, pointing out that the problem in Japan was exacerbated by its government&#39s failure to act swiftly and appropriately. Hargreaves Lansdown head of research Mark Dampier says: “There is always a danger of consensus of opinion when no one really knows. There are sectors that are deflationary but then there often have been – deflation has existed in electronic goods for years. I do not think we will fall into the same trap as Japan but then perhaps too many people have been talking about how it could not happen here.”

Dampier believes there will be price stability in the long run – disinflation as opposed to deflation – but he says he would not rule out deflation reaching Britain.

As an example of the precariousness of the situation, he points to Germany which, while not in recession, has interest rates double what he believes they should be because the European Central Bank was slow to react to the problems in Japan. With unemployment already running at 10 per cent and an inflexible employment structure, Dampier says Germany is under severe pressure.

One of the problems facing the UK, according to some IFAs, is the potential for importing deflation. Bates Investment senior investment adviser Paul Illot says: “There is the danger of importing deflation because we are in an environment where companies are looking to cut costs – outsourcing functions to the Far East and importing lower cost materials, for instance – which make prices cheaper. But when you have the manufacturing and service sectors pulling in opposite directions, the risks are not clear cut.”

Nevertheless, Illot says the UK – and the US, to a certain extent – is in a reasonably strong position to cope with any potential crisis. At 4 per cent, interest rates are low but have scope to be cut further, giving the Bank of England some ammunition to combat deflationary pressures. Allied with the fact that the underlying rate of retail price inflation crept closer to the Government&#39s target of 2.5 per cent last month, rising to 2.1 per cent from 1.9 per cent in August, and the UK&#39s situation does not seem as bad as previously feared. In fact, Bank of England governor Eddie George has stated that interest rate cuts may not be necessary.

Yet there is a school of thought that suggests mild deflation could actually benefit the economy. Wade believes that, under the right circumstances, deflation could have the positive effect of unleashing greater consumer spending. He says: “If deflation is a supply side-effect generated from greater returns from labour or capital, rather than a slump in demand, then falling consumer prices in certain goods means disposable incomes can go further. Lower prices means more income can be released into other parts of the economy, thereby generating higher returns.”

Wade gives the example of TV and video equipment, which has fallen in price due to productivity improvements and increased low-cost supply from Asia. He says this has given a real boost to consumers and has assisted with the efficient allocation of resources in the economy.

But Wade concedes the danger, as in Japan, is that if unprofitable companies are allowed to remain in business, the result is consistent downward pressure on prices and profits.

Even if deflation would not necessarily cripple the economy, there is little doubt it is a prospect that most people would rather avoid. It seems they will. As much as fund managers have a vested interest in playing down the danger, it seems clear that, barring any calamitous and unforeseen eventualities, deflation has little chance of washing up on these shores.

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