Deflation looms as cost of living falls

Deflated baloons

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."



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