KEY POINTS:
BNZ is forecasting annual inflation to fall to 0.9 per cent by next September.
The latest Nobel laureate in economics, Paul Krugman, tells us that deflation, not inflation, is now the greatest concern for the world economy.
And lately it has become commonplace to hear that an avalanche of selling on this or that globally significant sharemarket reflects fears of deflation.
So what is it, and why does the very word make the blood drain from policymakers' faces?
Like another D word, depression, it should be reserved for something really bad, a kind of economic quicksand.
Deflation is an extended period of falls in the general level of prices.
It occurs when demand is so weak for so long that firms keep cutting their prices to attract buyers. That becomes pernicious if it becomes embedded in expectations, so that people put off buying things in the belief they will be cheaper later, reinforcing the weakness of demand.
It can render the normal monetary policy instrument of an official cash rate impotent. Zero is as low as a nominal interest rate can go, but if prices are still falling the real interest rate will be positive and a drag on growth, as in Japan's lost decade. And it increases the real burden of debt.
Don Brash, speaking in the late 1990s, described the danger in this way:
"Falling prices that locked economies into a downward spiral in which shrinking demand and deepening pessimism led to sharply increased unemployment and serious banking difficulties. This could be associated with a sharp contraction in money and credit and probably with falling asset prices."
Sound familiar?
If such a trend developed simultaneously in large parts of the world economy it would be facing a serious deflation problem for the first time since the 1930s, Brash said.
New Zealand has not experienced deflation since the Great Depression and before that the Long Depression of the 1870s and 1880s.
Economists regard domestic deflation as a fairly remote possibility.
After all, annual inflation hit an 18-year high of 5.1 per cent in September, and non-tradeables inflation (the 54 per cent of the consumers price index unaffected by world prices and the exchange rate) has been stuck around 4 per cent for four years.
But that was then and this is now.
BNZ is forecasting annual inflation to fall to just 0.9 per cent by September next year. That would put it outside the seldom threatened lower bound of the Reserve Bank's inflation target band of 1 to 3 per cent.
"Inflation is collapsing," the BNZ's head of research Stephen Toplis says.
Much of this is the reverse of the sharp rise in inflation which was due to soaring world prices for oil and other commodities earlier in the year.
Oil prices have dropped by almost two-thirds from their July peak in US dollar terms and have halved in New Zealand dollar terms.
And the same drop in dairy prices which has caused Fonterra to slash its forecast payout ought to bring some relief for local consumers.
The falling exchange rate would normally drive up the prices of imported goods, but when demand is as feeble as it is now it is liable to be business profit margins, rather than the consumer, that take the hit. During the last two recessions, in 1998 and 1991, a sharp drop in the exchange rate was accompanied by falling inflation.
Meanwhile non-tradeables inflation, Toplis argues, has tended to track the output gap. The recession is in the throes of bringing about a shift from excess demand to excess supply, relieving those pressures.
All of this leads him to expect only a couple of quarters of little or no inflation, not the kind of deflationary quagmire people have started to fret about overseas.
But New Zealand is very exposed, through both trade and credit markets, to how the rest of the world fares.
When something like US$12 trillion ($22 trillion) of wealth has evaporated in the United States alone all the world feels the effects. You would probably need to be a Buddhist monk in an especially remote valley of Bhutan to escape the fallout altogether.
The OECD, in a grim economic outlook issued yesterday, says many developed countries are in, or on the verge of, a protracted recession of a magnitude not seen since the early 1980s, exposing some of them to a risk - "albeit small" - of deflation.
Last month consumer prices fell 1 per cent in the United States, the steepest one-month fall in 61 years.
The OECD expects annual US inflation to drop to 0.3 per cent by the September quarter next year, but then to rebound to more than 1 per cent after an unrepeatable US$90 drop in the oil price falls out of the annual number.
But the Federal Reserve has already cut its policy rate, the Fed funds target, by 425 basis points to 1 per cent, uncomfortably close to the "zero bound".
Unsurprisingly people have been rereading a speech Ben Bernanke, now the Fed chairman, gave on deflation six year ago. He stressed that a central bank whose policy rate has been forced down to zero "has most certainly not run out of ammunition".
It can engage in quantitative easing. "Normally money is injected into the economy by asset purchases by the Federal Reserve. To stimulate aggregate spending when interest rates have reached zero the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets it buys."
And indeed it has just announced an US$800 billion plan to buy mortgage-backed and other debt.
It could also target longer-term interest rates by buying Government bonds, Bernanke said.
But Krugman, who has made a study of Japan's experience of deflation, harbours doubts.
"While such measures would probably have a substantial short-run impact, they would only be effective in the longer term if the central bank were actually to acquire a substantial share of the relevant assets outstanding - which would raise some uncomfortable questions about the central bank's role."
In New Zealand's case the Reserve Bank is an awfully long way - 650 basis points to be precise - from having to worry about how to stimulate the economy when the official cash rate is zero.
The money market is pricing in a cut of 125 basis points next week. Such a deep cut would be unprecedented, but then so was last month's 100-point cut.
These are exceptional times. With inflation pressures receding fast, and inflation expectations falling, the bank has a green light to put all its weight on the accelerator.
