WHEN a country’s inflation rate goes into contraction, what does it really imply about the economy? Are prices of goods and services really falling, benefitting all consumers, or is it a symptom of something worse to come?

In layman’s term, price deflation refers to the decrease in prices of goods and services within the economy, when the inflation rate contracts and falls below 0%.

However, we must look deeper into the breakdown of the index that calculates the inflation rate, in Malaysia’s case, the Consumer Price Index (CPI).

During the Global Financial Crisis (GFC) period, the Malaysian economy fell into deflation for six consecutive months from June until November 2009, contracting between 0.9% year-on-year (y-o-y) to 2.4% y-o-y.

Prior to that, prices of goods and services soared as high as 8.5% y-o-y while our country’s gross domestic product (GDP) growth was already declining by 5.8% y-o-y before entering the deflation period.

According to the Statistics Department, our economy was experiencing a deflation when the CPI contracted in the first two months of 2019 by 0.4% y-o-y and at 0.7% y-o-y respectively, a first time occurrence since the GFC period in 2009.

However, the CPI has been steadily expanding below 1.0% y-o-y from June 2018 until December 2018, before the two months of deflation period. At the same time, GDP growth has been increasing at a healthy pace of 4.5% y-o-y in the second half of 2018 and is expected to grow at a similar pace in the first quarter of 2019.

Therefore, it may raise some questions among the public – is the current deflation period a temporary phenomenon, or will it prolong and become severe enough to prompt the government into an intervention using fiscal or monetary policy measures similar to those used during the GFC period?

Many people would think that a deflating economy is always associated with difficult economic times, for instance, deteriorating GDP growth or high unemployment like it was in Japan since the early 1990s or in the United States during the Great Depression.

Yet, not all deflationary periods are associated with poor economic conditions. According to the World Bank, inflation rate in Japan contracted at an average of around 0.5% yearly from 2000-2005, but the GDP was still growing at an average of 1.5% y-o-y – above its 2000-2017 average growth of 1.0% y-o-y.

Nevertheless, it is worthy to note that the same severe GDP contraction as seen during the GFC is unlikely to occur at present with industrial production growth still expanding steadily at a healthy pace.

Are prices really falling?

Moving back to breaking down the components of CPI, consumers in general, did not really feel any positive and material impact when CPI contracted in the first two months of 2019.

Our analysis shows that CPI fell mainly due to the drop in transport segment (January: -7.8% y-o-y and February: -6.8% y-o-y), following the fixing of RON95 and diesel prices in recent months. The impact of the pump prices is sizable on overall index, with the transportation index accounting for 14.6% of overall CPI.

However, the core inflation which excludes the volatile items from the CPI basket (food and transport segments) expanded by 0.3% y-o-y, indicating underlying inflation and prices of non-core items remains high.

Consumers may have temporarily benefitted from lower prices for petrol and certain goods.

However, as a weighted average of 12 sub-components in CPI, the cost has outweighed the benefits. As such, falling headline inflation does not necessarily mean that the prices of all goods and services in the economy are falling.

On a positive side, falling transportation costs offset the rising prices of two essential items in the CPI basket. These are food and non-alcoholic beverages as well as housing and utilities.

Lower cost of living?

To determine whether low or negative inflation will translate into lower cost of living, we need to analyse the breakdown of household consumption expenditure pattern. Based on the findings by the statistics department in 2016, rising inflation generally affects the bottom 40% (B40) households more than the middle 40% (M40) households, given their spending patterns.

Since the wages and salaries have remained sticky downwards, high cost of living would remain an issue in the long term.

In 2016, the statistics department reported that the mean for monthly household consumption expenditure increased to RM4,033 in 2016 from an average of RM2,574 during the period of 2003 to 2014.

On the other hand, Bank Negara stated in its annual report in 2018 that the mean expenditure of the B40 households has expanded at a faster pace compared to their income. From 2014 to 2016, B40 household expenditure jumped 6.0% (2016: RM2,284 per month; 2014: RM2,027 per month), higher than the average income growth (+5.8%) in this category.

Spending pattern

The B40 households spent most of their income on food (25.5% of total consumption), utilities (24.7% of total consumption), and transport (11.8% of total consumption). If we were to compare the CPI in the first two months of 2019, prices of food and utilities were still rising steadily (+1.0% and +2.0% respectively).Therefore, it is not surprising why most consumers are still complaining about the rising cost of living despite contraction in inflation, since food and shelter are classified as basic human survival needs according to Maslow’s Hierarchy of Needs.

In order to bring down the cost of living to a manageable level, there is still much to be done by the government, especially for the B40 group.

Sky-rocketing inflation rate or negative inflation rate are both unhealthy for an economy in general. Most central banks tend to set their inflation rate target at a comfortable level of 2%.

Thus, it is very much necessary for the government to undertake policies that could stimulate demand-pull inflationary pressures back to our economy by focusing on income and labour productivity growth.

Nevertheless, we expect this deflationary period to be short-lived, as inflationary pressures are expected to normalise towards the second half of the year after the implementation of proposed targeted subsidies for pump prices.

In fact, the targeted subsidies will likely cause inflation within the transport sector to trend higher since the price ceiling would only be applicable to the targeted B40 group. After the implementation, pump prices for other consumers will revert to the weekly floating mechanism which adheres to the Brent crude oil price level.

On a positive note, Bank Negara has forecast GDP to expand between 4.3% and 4.7% in 2019 against the backdrop of a challenging global environment.

Responding effectively to future jolts to the economy is crucial in preserving the growth of our nation.

Manokaran Mottain is the chief economist at Alliance Bank Malaysia Bhd.