Big fall in the cost of living
The cost of living fell sharply in December, prompting concern that the UK is fast heading into a dangerous cycle of deflation.
Meanwhile, the Retail Prices Index (RPI) – which includes mortgage interest payments – also slowed to 0.9% in December - down a whopping 2.1% from 3% in November.
The VAT cut in December – especially on women’s clothes and shoes – made the largest contribution to the fall in CPI, but the pre-Christmas sales as well as cheaper petrol also helped bring down the cost of living.
The average price of petrol fell by 6p per litre between November and December, to stand at 89.2p, compared with a rise of 1.7p in 2007. Meanwhile, diesel prices also fell, by 6.4p per litre to stand at 102.4p, compared with a rise of 3p in 2007.
Despite the sharp falls, inflation remains above the government imposed 2% target. And experts largely predicted inflation would fall further in December to 2.6%.
However, with discounts in the high street likely to continue, and cheaper energy bills expected in the spring, the cost of living is likely to continue to fall.
The Bank of England interest rate, used to control inflation, currently stands at its lowest level in the central bank’s history, and economists are concerned that all these factors puts the UK at risk of entering a period of deflation.
While falling prices could be regarded as a good thing for consumers, they could also prolong the economic downturn - essentially turning a recession into a depression.
Jonathan Loynes, UK economist at Capital Economics, explains: “While a short period of falling prices could help boost household budgets and the economy, it also risks people putting off spending in the hope of lower prices ahead."
The danger is that if deflation becomes entrenched in wages it could be hard to escape from, as not only do consumers delay spending but businesses put off investing until it is cheaper to do so.
Loynes expects inflation to turn negative over the summer.
He warns that there is a growing danger of a fundamental and longer-lasting period of deflation ahead.
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.
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.
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.
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).
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).