Big fall in the cost of living

20 January 2009

The cost of living fell sharply in December, prompting concern that the UK is fast heading into a dangerous cycle of deflation.

The Consumer Prices Index (CPI) – the official measure of inflation – fell to 3.1% in December, down a full 100 basis points from 4.1% in November and 4.5% in October. It peaked at 5.2% in September.

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.

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