Is the UK in the early stages of deflation?
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Version 0 of 1. Blink and you’ll miss it. That sums up what the experts think about inflation turning negative in the UK for the first time since 1960 – a time when Dwight Eisenhower was the US president and before the pre-fame Beatles had played a single note in Hamburg. That year, the period when the annual cost of living was falling proved to be brief, and the expectation is that it will be this time too. Why? Because the reason inflation has dipped below zero is largely due to the halving of oil prices in the second half of last year. Unless those falls in the cost of crude are repeated this year – and it’s almost certain they won’t – inflation will start to pick up again. The timing of Easter – which has an impact on the cost of air and sea travel – was also a factor. So, for now, it is a mistake to say the UK is in the early stages of Japanese-style deflation. Deflation is where prices fall across the board for a sustained period. It is an environment in which consumers put off making major purchases because they assume that the TV, car or freezer they want will be cheaper in the future than it is today. With consumer confidence high and unemployment falling, there seems no immediate prospect of this happening. Indeed, the opposite may well happen, with consumers tempted to increase their spending because their monthly pay cheques stretch further. Earnings growing at around 2% a year in conjunction with inflation 0.1% lower than a year ago equals a modest increase in real incomes that are likely to keep shop tills jangling in the months ahead. A cut in average earnings growth from 2% to 1% would suggest the economy was in a downward wage-price spiral All that said, a wary eye needs to be kept on the inflation numbers. Core inflation – the cost of living excluding volatile items such as energy and food – fell to 0.8% in April, the lowest since 2001. If it fell further, the risk of deflation proper would increase. The unknown factor that could push core inflation lower is wages. Despite two and a half years of steady growth and shortening dole queues, earnings are still only growing at around their pre-crisis levels of 4%. The Bank of England believes they will start to pick up because firms will struggle to find workers from a shrinking pool of labour. But if the supply of labour continues to increase, employers could respond to falling inflation by making their pay offers less generous. A cut in average earnings growth from 2% to 1% would then suggest the economy was in a downward wage-price spiral. Could this happen? It looks unlikely, but yes, it could. The US has had a poor start to 2015; Chinese growth is slowing; the eurozone remains highly fragile, and George Osborne has a budget coming up in July that will make further cuts to public spending and benefits. A period of slower global and domestic activity looks highly probable. For the moment, Britain is enjoying the good side of negative inflation, because real wages are rising and the Bank of England is going to keep interest rates at historically low levels. But there is a dark side to falling prices: deflation is hard to shake off when it gets a grip. One particular issue is that when prices are falling, paying off debt becomes more expensive. With Britain being a heavily indebted state, even an outside risk of real deflation needs to be taken seriously. |