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 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.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
Invented by a Frenchman in 1954 and ironically introduced in the UK on 1 April 1973, VAT is an indirect tax levied on the value added in the production of goods and services, from primary production to final consumption and is paid by the buyer. Its levying is complex, with a number of exemptions and exclusions. For example, in the UK, VAT is payable on chocolate-covered biscuits, but not on chocolate-covered cakes and the non-VAT status of McVitie’s Jaffa Cakes was challenged in a UK court case to determine whether Jaffa Cake was a cake or a biscuit. The judge ruled that the Jaffa Cake is a cake, McVitie’s won the case and VAT is not paid on Jaffa Cakes in the UK.
Monetary Policy Committee
A committee designated by the Bank of England to regulate interest rates for the UK. The MPC attempts to keep the economy stable, and maintain the inflation target set by the government and aims to set rates with a view to keeping inflation at a certain level, and avoiding deflation. The MPC meets on the first Thursday of each month and discusses a variety of economics issues and constitutes nine members: the governor, the two deputy governors, the Bank’s chief economist, the executive director for markets and four external members appointed directly by the Chancellor.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
This is the opposite of inflation and refers to a decrease in the price of goods, services and raw materials. Economically, deflation is bad news: the only major period of deflation happened in the 1920s and 1930s in the Great Depression. Not to be confused with disinflation, which is a slowing down in the rate of price increases. When governments raise interest rates to reduce inflation this is often (wrongly) described as deflationary but is really an attempt to introduce an element of disinflation.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).