Is deflation a blessing or curse?

It is likely that 2008 will go down as one of the most financially turbulent in history. For British households, there have been plummeting house prices, failing banks and a pending recession to contend with. In addition, the increasing cost of living - specifically the rising cost of petrol, energy bill hikes and higher food prices - has put pressure on many people's budgets.

Inflation steadily rose throughout the year, hitting 5.2% in September - well above its 2% target. The rise in inflation has largely been down to the cost of crude oil, which peaked at nearly $150 a barrel in the summer, and commodity prices.

But inflation now appears to have peaked; the Consumer Prices Index (CPI), which the Bank of England uses as its official measure of inflation, fell to 2.3% in April, down from 2.9% the previous month.

Meanwhile, the Retail Prices Index (RPI) – which unlike CPI includes housing costs such as mortgage interest payments – has also experienced a dramatic fall since last September; it turned negative in March, but has now fallen further to -1.2%. This is the lowest figure since records began in 1948.

With food and petrol continuing to get cheaper, and energy bills starting to fall, economists believe inflation will continue to slow and CPI will turn negative at some point in 2009. The fact that shops have been forced to offer big discounts, along with the cut in VAT, should also speed up the fall.

Capital Economics says the the drop in crude oil costs (which has already started to feed through into petrol and energy bills) and cheaper food at the supermarket are set give birth to a period of deflation.

Impact of deflation

Jonathan Loynes, chief European economist at Capital Economics, says that a short period of deflation would have a positive impact on economy as cheaper prices can boost confidence and spending power.

However, James Carrick, investment strategist at Legal & General, points out that a climate of deflation tends to deter people from spending as they would rather wait a while until prices are even cheaper.

This behaviour has been seen in the housing market, with many commentators putting plummeting demand for property down to a lack of consumer confidence about the future of property values as well as restricted access to mortgages.

Loynes agrees that there is a risk that deflation could become embedded in the economy, with the anticipated recession threatening to create a prolonged period of falling prices.

The risks

The last time inflation turned negative was in 1947 at the end of the Second World War. In the 60-plus years since then, the UK has generally experienced positive inflation with price rises year-on-year. Although inflation was very high during the 1970s, the past decade has seen only a modest inflation.

Not every country has been so lucky. Sweden and the Czech Republic have both suffered from deflation in recent years, while Japan has been trapped in a cycle of falling prices since around 1998.

Although it the UK has been spared the trials of deflation for over half a century, economists are now concerned 2009 could be the year when things change.

Capital Economics points out that, until the 1940s, deflation in the UK was fairly common. And although the economy has matured since that time, falling oil and commodity prices (plus the fact that the UK is on the edge of a recession) mean current conditions in the UK are not that dissimilar to periods in the past when inflation strayed into negative territory.

Although there is an argument that increases in import prices and quantitative easing measures announced by the central bank could put upward pressure on the CPI (thus ruling out a period of deflation), Loynes says it seems likely that a deep recession will have a “powerful disinflationary effects”.

He also warms that there is a growing danger of a fundamental and longer-lasting period of deflation ahead.

It seems likely that the Monetary Policy Committee (MPC) is also aware of the dangers deflation presents, bearing in mind the dramatic interest rate cuts that have seen the base rate reduced to just 0.5% - an all-time low. Carrick points out that because the UK is a nation of borrowers rather than savers, and deflation increases real debt, monetary policy going forward is likely to be geared towards avoiding a period of deflation.
"The broad picture is for inflation to continue to run well below [the government’s 2%] target," deputy governor of the central bank Charles Bean told the National Farmers' Union in Birmingham on 16 February.

Who’s afraid of deflation?

Deflation is defined as falling prices - bearing in mind the squeeze inflicted on household budgets this year as a result of inflation, that may not sound like such a bad thing.

Capital Economics says deflation doesn’t have to be bad news; it argues that a relatively short period of negative inflation will boost incomes and confidence.

However, a prolonged period of deflation is more serious. John Higgins, senior market economist at Capital Economics, admits that the “poisonous cocktail” of over-indebtedness and falling prices that we are current seeing have also been behind some of the great deflations of the past.

The danger is that if deflation becomes entrenched in wages it could be hard to escape from and could make the recession even more painful.

Richard Snook, senior economist at the Centre for Economics and Business Research, says: “The primary danger is that once deflationary expectations are entrenched, consumers will delay spending and businesses will delay investing as this can be done more cheaply in the future. As a result, deflation can contribute to downward economic spirals and turn a recession in to a deep and lasting depression.”

If deflation does feed into wages, then debt actually increases. Positive inflation over a period of time means asset values increase and thus the burden of debt decreases. However, with deflation, prices and wages falls and the burden of debt increases.

In a period where households are already feeling financial strain, unemployment is rising and the economy has gone into decline, deflation is a far from welcome addition to the party.

Deflation is bad news for borrowers, but also for people invested in equities.

According to Capital Economics, falling prices mean the gap between investors’ required rate of return and expected growth rate of corporate earnings can grow unchecked when prices are falling, theoretically at least.

This is because earnings decline under deflation, but interest rates cannot fall below 0%.

Deflation isn’t bad news for everyone. During periods of high inflation, savers have seen the value of their nest eggs eroded and their buying power diminished.

Falling prices technically mean your money goes further. But this only applies if you don't have any debt and your income is fixed.

So, if you are a saver with a fixed income - such as a retiree - then falling prices mean your money goes further and you could benefit from deflation.