Deflation looms as cost of living falls
The cost of living has fallen below target for the first time for two years, with food prices falling between May and June.
The Consumer Prices Index (CPI) – the official measure of inflation – hit 1.8% last month, down from 2.2% in May and 2.3% the previous month. Meanwhile the Retail Prices Index (RPI) – which includes mortgage interest payments – remained negative at -1.6%. This is the lowest RPI figure since records began in 1948.
One of the main remits of the Bank of England is to ensure that the CPI is within 100 basis points of its 2% target. This is the first time CPI has fallen below target since September 2007.
The Office for National Statistics (ONS), which publishes the figures every month, says falling food and non-alcoholic drink prices were the main reason for the fall in inflation. Meat, bread, fruit and vegetables and dairy products experienced the biggest price falls.
A significant downward effect also came from furniture prices, which rose by less than last year.
June’s inflation figures are significant because they show that the cost of living continues to fall, despite action by the Bank of England (namely, the creation of new money through quantitative easing) that some experts believe could cause inflation to rise sharply.
Jonathan Loynes, chief European economist at Capital Economics, says that the rising cost of crude oil in recent weeks has also prompted speculation of inflationary pressures.
But he adds: “June’s figures confirm that inflation is still on a firm downward trend. […] the bulk of the disinflationary effects of the deep recession in the economy have yet to be seen.”
The Bank of England has also forecast that CPI will remain low, possibly dropping below 1% this year as falling demand knocks prices.
Unemployment and pay freezes, as well as businesses feeling the effects of the recession, are really taking their toll on prices, says Howard Archer, of IHS Global Insight.
“We suspect that even if the current improvement in economic activity is sustained, it will not be strong enough for some considerable time to come to significantly lift underlying inflationary pressures,” he adds.
However, Benjamin Williamson, an economist at the Centre for Economic Business Research, argues that inflation should be lower considering the depth of the recession. He says that the historically low interest rate (0.5%) and quantitative easing are likely to prevent the UK from becoming stuck in a period of deflation.
But he adds: "The rate of change in consumer prices will remain structurally lower for some time, largely due to continued low wage inflation feeding through to consumer prices. Our latest forecasts for the UK economy show inflation spiking as the VAT cut is reversed in January 2010, but then falling back below the 2% target as spare capacity continues to put downwards pressure on wages and prices."
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.
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.
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).
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).