Simple lines leave the deflation riddle unsolved

When will it ever end? The latest consumer price index report shows prices still dropping. We have now been in deflation since May 1998; how much further do we have to go?

It is a question that many economists looking at Hong Kong have asked and, as usual for economists, there is very little agreement between them. Why not add to the disagreement? Here we go.

Let us start from the assumption that the biggest governing factor is the currency link to the US dollar. This assumption says that there is open and free trade between the United States and Hong Kong and, if the exchange rate is fixed, then there should not be much difference between them in prices of consumer goods.

If there were, then clever traders would take advantage of the disparity and their arbitrage of these prices would bring inflation rates back into line.

It does not work quite as neatly as that and certainly not as quickly but it must clearly be an influence on prices in Hong Kong and the deflation we are now experiencing is evidence of it.

So let us go back to January 1984, three months after the peg to the US dollar was adopted and assume that prices then were pretty much at the same level in both the US and Hong Kong. We shall thus restate the CPI of each on a basis of January 1984 equals 100. What does the picture look like now?

The first chart shows you the answer. We still have a long way to go, years in fact, before our consumer prices come back in line with those in the US. If this chart tells the story and differences with US inflation are the most important determining factor of Hong Kong consumer prices, then tighten your belts. The end of deflation is not yet in sight.

But we have made one assumption here that needs further questioning.

We have assumed consumer prices were roughly the same in the two economies in January 1984.

Who says they were? We picked that date only because three months after the peg was adopted was a reasonable period to expect it to start settling in.

Let us pick another starting date instead, January 1980 let us say, because it was the start of a decade. This is still an arbitrary choice but then all dates are.

Let us also take into account the fact that the US dollar exchange rate at the end of that month was HK$4.86 and adjust our inflation index when making comparisons with US inflation, something we have not had to do since the peg was adopted.

The second chart shows you where we are relative to the US on this basis, almost back in line again. A few more months should do the trick and then there will be no reason for our prices to fall any longer. Deflation will be history by early next year.

Which of these two is the correct way of looking at the deflation picture? Unfortunately there is no hard and fast answer. This is a simplistic model and all it really tells us is to be careful of forecasts based on such things. We have too many of them.

Graphic: jake23gbz