The BOE rate cut of 1.5% announced today was the biggest in its history, and had most of us scraping our jaws off the floor. Why did they cut rates so aggressively? There are, of course, several answers. Some of the more obvious ones are that they wanted to continue to improve bank lending rates and stimulate consumer spending.

However another reason is hinted at in their official press release. In it they say “In recent weeks, the risks to inflation have shifted decisively to the downside”. Also that the bank’s forecast “at prevailing market interest rates, contains a substantial risk of undershooting the inflation target.”

The opposite of inflation is deflation – and if you thought inflation was bad, well, deflation is even worse. So far central bankers have been denying deflation is a threat. However the media has been full of speculation about deflation and, with this BOE rate cut it’s only going to increase.

If you want to see how I traded this historic event (forgive my sense of drama) then have a look at my most recent trade dairy.

However if we want to really understand what’s going on we need to go back to school. We need to remind ourselves of the basics of inflation/deflation and the worst case scenario is: the dreaded deflation / depression double bill.

What Is Deflation?
Ok, we all know about inflation (that’s when we have rising prices). Then there’s stagflation, which is a nasty cocktail of rising prices but with slowing growth (click on the link if you’re wondering ’What is stagflation?’). Well, if you take the next stop down the line you get deflation. This is the opposite of inflation and, in simple terms, means ‘a general fall in prices’.

Why’s It Such A Problem?
In honour of Lewis Hamilton’s stunning Formula One championship win over the weekend I’ll use a driving analogy; if he’s belting round the track with his tyres properly inflated then he’s probably on course for the World Championship. If there’s too much inflation then his car will go fast but he’ll have to battle hard to stay on track and at some point he’s likely to come a cropper. If, however, his tyres are deflated his car will be slow and he won’t be going anywhere.

Although the concept of falling prices is pretty appealing, let’s just work through the effect this has on the economy. Let’s start with the Paradox of Thrift. This is another Keynes special and, in easy language, states that if one person starts saving for a rainy day he improves his financial position. However, if everyone starts saving then collectively they make their financial positions worse.

This is because if people are saving then they’re not spending as much, so consumption slows. If fewer goods are being consumed then firms will produce less; this leads to job cuts and lower incomes, so people cut back more on their spending. Repeat this process a few times and you’ve got a deflationary spiral.

The unpleasant consequences of deflation are, at best, a recession or worse still a depression. It’s the fear of depression that’s spooked the world’s central bankers.

What Causes Deflation?
There are three broad ways (that are interlinked) that cause deflation:

1) Money Supply. OK, I’m sorry. I tried to avoid it, but I can’t talk about deflation without mentioning “money supply”. No! Come back, I’ll try and keep it brief.

Back in the days when Bob Geldof swapped his Rats for a Band Aid, money supply data was the height of fashion; it was one of the ‘must watch’ indicators of its time. This was when the banking sector was far less complicated and the popular theory was that you controlled inflation by controlling the money supply.

I’ll stick in the link for insomniacs but essentially money supply measures the amount of money in circulation. There are two main measures, narrow money, which looks at the amount of cash in people’s pockets plus the banks’ deposits at the government’s central bank. The other measure, broad money, also includes all the money in individual’s and companies bank accounts.

The theory is that if the money in circulation increases then so does inflation (with a time lag). And as a central bank can decide how many bank notes to print they can, at least in one way, vary the amount of money in circulation quite easily.

Let’s put it another way. You’re down the pub with Sean and Wayne, but it’s the end of the month and after buying a round each the pockets are almost empty. Your group’s money supply is down to £2. The only way the pub can get you to buy anything is by dropping its prices. But what’s this? Your canny £2 investment in the fruit machine produces a line of cherries and the machine rewards you by spewing out £100 worth of gold coins. Your money supply is now £100. Your winnings allow you to buy another round of drinks and repay Sean and Wayne the £30 you owed them. They both respond like true gents and buy another couple of rounds each. That night the landlord decides to spend his extra takings on a takeaway for him and his missus. The owner of the takeaway shop is so pleased that he pops in to the late night corner shop and treats his wife to some choccies and the kids to a DVD. On the way out he bumps into you popping in for…….oh you get the picture?

Your welcome injection of cash, by passing through several hands, kick-started a chain of purchases that otherwise wouldn’t have happened. Now, on that scale it’s not going to move prices. However, if you substitute the fruit machine for a central bank that prints a whole load more notes and spread them around a bit, you can see how suppliers would have more scope to increase their prices.

2) Supply & Demand. The supply of goods being greater than demand causes prices to fall. This is the basic principle of supply & demand; the producer needs to cut either the price, or supply, or both to meet the level of demand. This leads to lower prices or lower output and we’re back to the spiral mentioned earlier.

3) Interest Rates. When interest rates are set too high relative to the level of growth in the economy it can lead to a sharp fall in prices. The more money that’s spent on debt interest, the less there is to spend on the fun things in life like Nintendo Wiis or Jimmy Choo shoes.

Here’s One We Made Earlier
Back in the late 1980s Japan’s economic bubble burst; plummeting share and property prices led to a period of deflation that it couldn’t shake for over a decade. The government cut interest rates to just above zero, and when this failed, the central bank pumped loads of Yen into the banking system by buying large amounts of government bonds, asset-backed securities and equities. Does any of this sound familiar?

The problem was that as the culture of falling prices took hold, it was hard to break the Japanese desire to save their money. After all, why would anyone want to spend when the economy is down, their jobs aren’t safe and that new car or television might be cheaper next year? Even now inflation is only 2.3% and their interest rates are at 0.3% – compare that to European inflation at 3.2% and interest rates at 3.25%.

Hey, if you’re not scared yet, check out the chart of the Nikkei. This index used to stand out because it had a crazy number of digits. The Nikkei was at 39000 in 1989 and is now at 8800 – nearly an 80% drop. If the same thing happens here then in 20 years the FTSE would be at 1500 and the Dow at 3000! Now that’s scary stuff.

How Would This Affect The Markets?

Commodities
Since July commodity prices have been destroyed by the fear of a global slowdown and less demand for materials. Even the threat of a financial meltdown didn’t attract investors to the safety of gold, and oil fell by over 50% from its summer high. Commodities are likely to continue to suffer if a period of deflation looks increasingly probable.

Government Bonds
Government bonds ought to benefit, as their fixed rate of interest would be worth more compared to lower official rates. Having said that, the monster levels of supply for years to come might well knock bonds with longer maturities for six.

Currencies
The Armageddon scenario for some is that a catastrophe like deflation could see the Eurozone ripped apart at the seams, leaving a German-French backed Euro and the weaker nations left to fend for themselves. These fears have been expressed through recent prices of government bonds. On Tuesday Ireland launched a new bond, but had to offer a rate of interest 0.25% higher than the average for European bonds. This, like Italian bonds, yields a full 1% more than German bonds, with Spain, Belgium and Portugal not far behind.

The Eurozone structure was meant to imply that all participants were of equal standing, their finances monitored and protected by the union. But what this difference in yields is telling us is that traders can see the possibility of the EU being blown apart. If this happened then countries like Italy, Ireland and a few others would be judged on their stand-alone ability to re-finance their debts.

Equities
Companies’ flexibility to raise prices helped them to cope with inflation; but if they respond to falling demand by slashing prices they’re still exposed to the fixed costs of assets and employees. The most likely sectors to suffer are consumer goods and manufacturers, along with banks and property companies. Equity sectors that might hold up would include those that produce the necessities in life, like pharmaceuticals, supermarkets and tobacco firms. Also those that would benefit from falling prices e.g. electricity companies that can buy cheaper oil but not pass on the full cost savings to their customers.

What’s The Anti-dote?
The threat of deflation has united governments around the world more than poverty, global warming or even their dislike of George Bush. We’ve seen a two-pronged attack with governments and central banks both playing their part:

1) Interest rate cuts. October 8th saw the first round of co-ordinated interest rate cuts; the second round has been spread over two weeks with the US and Japan cutting by 0.5% and 0.2% respectively last week and the UK and Europe cutting rates today. Although the ECB stuck to the script, the Bank of England shocked everyone with a mammoth 1.5% cut. We now have the unprecedented situation of UK rates being lower than those in Europe.

2) Money Supply. Money is being printed as never before. Governments are flooding their economies with billions of dollars and there’s no sign of any let up. Beardy Ben Bernanke spent his previous life studying the 1929 Great Depression and reckons he knows how to stop it happening again-throw helicopter loads of Dollar bills at the problem. I’ve lost track of how many rescues each government has now announced, but each new measure seems to be reaching further into the wider economy.

Conclusion – Will it Happen?
In 2007 we were all watching inflation carefully to see whether Europe and the UK would raise interest rates to combat rising prices. Now we are all watching the data carefully for deflation. However, while the chances are against deflation, if it were to happen it could be extremely serious (you’ve just read about the mess that Japan got into). Deflation could be a lot harder to beat out of the system than inflation and is linked in a lot of people’s minds with depression.

Deflation and depression are much scarier than inflation and recession. Hence any signs of it in any country could send that stock market and that currency tumbling.

Could the BOE cut be such a sign? Answers below please …