Will falling inflation leave you out of pocket?
The cost of living has dropped below target for the first time in two years, with food prices falling between May and June. The Consumer Prices Index (CPI) – the official measure of inflation – hit 1.8% in June, 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 RPI initially turned negative back in March, the first time it strayed into negative territory since 1960.
The fact that both measures of inflation remain low, with RPI still negative, is significant bearing in mind action taken by the Bank of England to kick-start the economy. The historically low base rate (0.5%) and the amount of money being pumped into the economy (known as quantitative easing) both carry inflationary risks, and some economists have expressed concerns that hyperinflation is just around the corner.
However, it seems that low demand for goods and services is keeping prices down and many commentators believe inflation will remain low for some time.
Jonathan Loynes, chief European economist at Capital Economics, says: “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."
And Benjamin Williamson, an economist at the Centre for Economic Business Research, 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."
A hero’s welcome?
Deflation might sound initially like a good thing for consumers. But as an economic cycle, it poses as many risks as it does benefits. While a short-term period of falling prices could give the economy a much needed boost, if deflation starts to drive down wages then it could turn a recession into a depression.
Given that RPI is used as a benchmark by many trade unions and organisations to gauge wage increases, experts forecast many employees could endure pay freezes - and even pay cuts - this year.
Vince Cable, shadow chancellor for the Liberal Democrat party, says that a short period of deflation is not necessarily a great cause for alarm. But he adds: “One of the worst things that can happen to any economy is that people start to believe that prices are on an ever-downward spiral and therefore delay making purchases."
Despite the risks of deflation, it could offer some benefits to your finances. But, as with most things in life, there will be winners and losers from deflation.
A period of falling prices will be welcomed by most households with a big purchase to make. Considering last year saw prices jump on the back of higher fuel costs, a change of direction couldn’t come soon enough.
European holidays, white goods and TVs, and furniture and homeware have all fallen in price, although items such as digital cameras, clothing and computer games have risen. Read more about what prices are falling
Of course, the danger with deflation lies in the fact that many people put off spending in anticipation that it could pay to wait as prices will fall further. Whether you defer buying until prices potentially fall further really depends on your specific circumstances.
However, deflation means the opportunities for haggling on price increase. Asking for a discount isn’t just a technique you reserve for when shopping abroad. Haggling over prices is becoming more common in the UK, as people increasingly get up the courage to be a little bit cheeky.
People tend to have their own style of haggling, but generally speaking being polite but firm is a good way to win a discount. Don’t try and push the price down too far – work out a price you’d be happy to pay and then suggest something a little lower. If the retailer doesn’t want to play ball then there is no obligation to buy and you can just walk away.
Remember, the worst thing that could happen is they say "no". You really do have nothing to lose.
* House renovators
Whether your plans to move up the property ladder have been thwarted by the credit crunch, or you simply have the money to make some improvements to your home, then 2009 could be the year to renovate. Not only can improving your property potentially increase its value, but it is also an alternative to moving.
And in a period of deflation, the cost of renovating could become cheaper. Builders and other contractors – including architects – could be more open to price negotiations.
Call round several firms in your area and get some quotes. With many businesses suffering during the recession, you may find they are desperate for your business – the fact that the cost of raw materials has also fallen in the past 12 months will also help your case.
As with shopping, don’t be afraid to ask for a cheaper price but, equally, try and be polite about it. Bullying your builder probably isn’t the best way to go about renovating your home.
Before you consider renovating your home, make sure you find out whether you need planning permission. For more details about planning applications and costs, visit planningportal.gov.uk.
You should also contact your insurer before you start work to make sure you are covered.
The basic state pension increased this April, a boon to those hit the hardest by 2008’s rising prices. Ironically, the rise in the basic state pension is largely down to the high inflation seen last year as the government updates the basic state pension each April, usually in-line with the previous September’s Retail Prices Index rate.
As this was 5%, individuals receiving the basic state pension will see their income increase from £90.70 to £95.25 a week. Couples, meanwhile, will see their payments increase from £145.05 to £152.30.
The rise also seen means pensioners will see their income increase at a time when the cost of living gets cheaper, or potentially even turn negative. Assuming recipients of the basic state pension don’t have high levels of debt (see below), their spending power will therefore increase on both fronts.
In the Budget, Alistair Darling pledged to raise the basic state pension by at least 2.5%, regardless of inflation, in April 2010. So, even if the UK does enter a long period of deflation, state pension income will be protected.
* Savers and investors
Savers haven’t had a lot to be cheerful about recently; since the Bank of England started to cut the base rate last October, returns on savings accounts have fallen to pitiful levels. With inflation still high, people’s nest-eggs could be eroding in value.
But what savers lose to inflation, they can gain from deflation as falling prices technically means your money goes further.
Average savings rates have fallen to dismal levels. However, even if the interest on your savings account has fallen towards the zero mark, a period of deflation will mean that, technically, your money is still growing. In addition, the fact that the Bank of England base rate is unlikely to fall any further has boosted rates on the market.
Andrew Hagger, spokesman for comparison website Moneynet.co.uk, says there is now more choice for savers. “Competition in the fixed-rate sector has been fierce and, as a result, basic-rate and higher-rate taxpayers will no longer find it a struggle to achieve a positive return on their savings," he adds.
Anyone with a fixed income could benefit from deflation – including some investors. Fixed-interest investments, such as government bonds, gilts or corporate bonds, pay a set amount of interest - as prices fall, the true value of that income (in terms of spending power) will rise.
However, when it comes to investing, there are a number of factors to consider. Speaking to an IFA is probably the best place to start.
* Small business owners
It’s been a tough few months for small business, thanks to the tough recessionary trading conditions and a lack of funding from banks. While these problems are not likely to go away over night, a period of deflation could actually be a spot of good news on the horizon for Britain’s small business owners.
A period of deflation could lower running cost for business owners, a welcome respite after the high inflation seen in 2008. Research from insurer MORE TH>N Business suggests that small businesses are already benefiting from falling inflation, with a 2.9% fall in costs in the final three months of 2008, thanks in part to cheaper fuel and raw materials.
Despite deflation offering a benefit to business owners, it could also come with a sting in its tail, as customers look to drive down prices. This might offset the benefit of cheaper running costs for businesses and cause further pain during an undeniably tough time.
“Small business owners will clearly have to demonstrate some acute financial acumen in order to balance the need to maintain margins whilst keeping product and service pricing in line with demand," advises Donald Kerr, commercial banking director at Bank of Scotland.
A lack of demand from consumers will also remain a problem for small businesses for the foreseeable future. And the benefits of deflation will be felt by some small business owners more than others, warns Mike Bowman, head of business at MORE TH>N.
“Deflation will come as good news for transport and haulage contractors as they will see fuel costs come down due to a sharp fall in oil prices,” he explains. “However, deflation is bad news for businesses that have their assets tied to property or large amounts of stock already purchased, as it will be losing value day-by-day."
Despite some areas benefiting from deflation, the fact remains that we are, on the whole, a nation of borrowers – and deflation is not good news for those with debts. This is because deflation increases the amount of debt against your name.
A good way to understand this is to look at house prices. Falling property values are bad news for homeowners because the asset they hold is decreasing in value but the debt secured on it (their mortgage) remains fixed.
It is, however, worth noting that interest rates should remain fairly low as long as the cost of living remains low or negative. One of the main considerations for the Bank of England when it sets the base rate is inflation – when this is too high, interest rates increase to help calm prices by making it more expensive for people to spend on credit. When inflation is low, interest rates technically should also remain low.
Low interest rates are good news for people with variable-rate mortgages and anyone with a tracker home loan will already be benefiting from lower monthly repayments. Standard variable rates (SVR) borrowers might also benefit, depending on whether their lender has passed the lower base rate on.
* Savers and investors
On the whole, savers should benefit from deflation – with one exception. People with inflation-linked savings accounts from National Savings & Investments, or Leeds Building Society, will not be too happy about the cost of living turning negative.
Last year, when inflation was high, many people attempted to protect their nest-eggs from its erosive effect by opting for inflation-linked accounts. At the time, NS&I and Leeds both offered such deals, which paid a fixed amount above the RPI. When this was 5% last September, these savers were laughing. However, as it has now turned negative the outlook is not so good.
Of course, on the plus side, falling prices still mean savers with inflation-linked accounts will see their spending power increase. But they won’t be earning anything like a decent rate on their cash.
Leeds Building Society’s Inflation Buster ISA and savings bond (which are no longer available) calculate the interest rate based on the rate on inflation on a set date in 2009 in year one and the same date in 2010 in year two. NS&I, meanwhile, pays 1% above the RPI on its inflation-beating certificates, with the interest paid on maturity. The terms are either three or five years.
The problem for anyone with this type of account is that if the certificate is repaid in the first year, then no interest or index linking is paid. If repaid after the first year, but before the end of the term, then a reduced rate is paid.
Deflation is also bad news for people invested in equities.
According to Capital Economics, 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%.
* Inflation-linked annuities
When inflation was high last year, inflation-linked annuities grew in popularity in the same way that inflation-linked savings accounts did. While the income from standard annuity products is static and can, over time, be eroded by rising prices, an inflation-linked product protects your retirement income.
Although payments will start off lower than a standard annuity, they will increase over the years enabling you to beat rising inflation.
Laith Khalaf, pensions analyst at IFA Hargreaves Lansdown, says in a deflationary environment, pensioners’ income will not rise – and could potentially fall, depending on the annuity provider.
When you take out an RPI-linked annuity, your provider will look at the rate of inflation three months in the past. When your anniversary comes round, your provider will take another look at inflation (three months prior to your anniversary date) and amend your rate accordingly.
So, people whose anniversary falls during a month where RPI is negative could be hit.
According to Hargreaves Lansdown, inflation needs to run at 5% a year for a RPI-linked annuity to be worthwhile.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
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.
Every mortgage lender has a standard variable rate of interest, or SVR, on which it bases all its mortgage deals, including fixed and discounted rate and tracker mortgages. When special deals come to an end, the terms of the deal usually state that the borrower has to pay the lender’s SVR for a period of time or pay redemption penalties. The lender’s SVR is, in turn, based on the Bank of England’s base lending rate decided by the Bank’s Monetary Policy Committee (MPC). Every time the MPC raises its rate, mortgage lenders generally increase their SVR by the same amount but when the MPC lowers its rate, lenders are often slow to pass this on or don’t pass on the full cut to borrowers.
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.
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).
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.
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).
A standard by which something is measured, usually the performance of investment funds against a specified index, such as the FTSE All-Share. Active fund managers look to outperform their benchmark index. Cautious fund managers aim to hold roughly the same proportion of each constituent as the benchmark, while a manager who deviates away from investing in the benchmark index’s constituents has a better chance of outperforming (or underperforming) the index.
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.
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
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).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
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 familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.