Deflation in Thailand?

When the capacity of the economy to supply goods and services (given by its factories, workers, etc.) exceeds demand, as happens in a crisis, there is pressure for prices to fall. A continued decline in prices (deflation) can in turn aggravate the economic crisis, because consumers expect prices will be lower in the future and so have an incentive to postpone purchases. They also fear that their wages (the price of labor) may decline along with other prices, and tend to save more. These factors further reduce demand and may create a vicious cycle, such as the one that happened in Japan in the 1990s.

But not all changes in prices are related to the underlying domestic economy. If price changes are expected to be "one-off" then the expectations of consumers about future prices do not change, and the logic above does not apply.

So far, the substantial year-on-year declines in consumer prices in East Asia in general and Thailand in particular have been attributed primarily to these "one-off" factors. This is with good reason: between March and July of 2008, a bubble in commodity prices (especially oil) led to a sharp increase in the prices of food and fuel, which make up a substantial part of the consumption basket measured by the consumer price index (CPI). By definition, a bubble is an increase in prices that is not supported by fundamental supply and demand forces, which is why bubbles eventually must burst. Once this happened, prices of food and fuels had to decline to return to levels compatible with supply and demand. So negative year-on-year inflation is to be expected at this time, and is unlikely, on its own, to reflect excess supply in the economy of the type that would create a vicious cycle of deflation.

But what if we look at prices except for the food and fuel prices that we know were higher than normal? Many governments calculate exactly this number, called "core inflation", which is the change in prices of consumer goods excluding food and fuel. Although changes in the prices of food and fuel can spill over to other goods, the idea is that changes in core prices should better reflect underlying domestic economic conditions as opposed to movements of volatile international commodity markets. The Bank of Thailand (BoT) targets a value for this core inflation rather than overall inflation, so this is the number most relevant to the outlook for monetary policy.

Unlike other countries in East Asia that report core inflation (only Philippines, Indonesia and Korea do), Thailand's year-on-year core inflation has been negative in for the past three months, with the decline accelerating between May and July, from -0.2 percent to -1.2 percent. But these declines could still be "one-off" if they just represent the spillover from food and fuel prices to other prices. What happens when we look at the increase of core prices on a month-on-month basis?

This chart shows core inflation rather stable in 2007, then picking up in all three countries in 2008: prices were increasing everywhere on a month-on-month basis, and at a generally increasing pace. This is the effect of the bubble of food and fuel prices. The pattern that emerges since the onset of the crisis is one of declining inflation, but Thailand is the only country with multiple monthly declines in core prices. In fact, average core month-on-month (annualized) inflation in Thailand has been -0.6 percent in 2009 compared to 2.0 percent in Korea, 3.8 percent in Indonesia, and 1.9 percent in the Philippines. So whereas prices have been increasing (albeit more slowly) in those countries, in Thailand prices continued to decline (between August and December, prices had already declined an average of 1.8 percent).

Still, it is possible that Thai core inflation is more negative than that in other East Asian countries because it includes prepared food, which is a non-trivial part of Thais' consumption basket. The price of prepared food depends on both fuel (cooking gas) and, of course, food, which could make inflation seem low while still just reflecting the adjustment in food and fuel prices rather than underlying economic activity. But consider this chart, which traces a proxy for the actual level of prices (as opposed to the changes) excluding all food and energy. Although the pattern is not entirely clear (and it is still possible that some of the declines are due to one-off events such as changes government-administered prices), the data suggests that after a sharp increase in 2008, consumer prices have now returned to the levels of 2006. 

This suggests it may be a while before the BoT starts thinking of raising rates—indeed the opposite may be true if evidence builds that negative core inflation is due to more than transmission from declines in commodity prices. A continuation of this deflationary pattern would not bode well for consumption if wages continue to decline along with prices: in the first quarter, real wages already declined by nearly 3 percent. Because deflation is a way to depreciate the real exchange rate, and given the perception by some that the Baht is "too strong", the downward pressure on wages is likely to continue in 2009.