Are we in deflation now? And other questions you were too scared to ask about 0% inflation

<b>Ben Chu</b> has the answers

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Are we in deflation now?

In all likelihood: yes. The Office for National Statistics reported that there was zero consumer price inflation in February. That means a representative basket of goods and services in February 2015 cost precisely the same as it did in February 2014. This is the weakest inflation figure recorded since the Consumer Price Index data series began in 1989. And according to an experimental longer-term Consumer Price Index series put together by the ONS this is actually the lowest inflation figure since 1960. There’s more to come too. Analysts expect the next official number (covering March) to be negative, which would mean the UK is now in outright deflation.

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So why are prices falling?

The latest recorded steep decline in the inflation rate, between January (0.3%) and February (0%), was driven by falls in food, toys and furniture prices. But the annual inflation figures show the big picture to be one of plummeting energy prices. Fuel prices are down a massive 16.6 per cent on the same month last year. The most tangible manifestation for most people is, of course, that the average price of a litre of petrol at the pump, which was fallen to 111p this month, down from 133p last summer. This, in turn, is being driven by a collapse in global oil prices. The price of a barrel of crude oil has have roughly halved since last summer, declining from $110 a barrel to $55 a barrel. Energy companies have also slashed household electricity and gas bills in response to the falling global oil price. And analysts think this is only now feeding through into the official figures. “It looks odds on that inflation will turn negative in March, when the cut in gas prices by British Gas (the utility company with the biggest market share) will show up in the inflation figures for the first time” said Vicky Redwood of Capital Economics. However, food is also making a sizeable contribution to the downward pressure on inflation. Prices were down around 3.3 per cent in February, a benefit of the intensifying supermarket price war.

Aren’t falling prices a good thing?

Many economists are certainly accentuating the positive from inflation’s collapse. Wages are now increasing faster, in annual terms, than prices for the first time since the financial crisis. Most City of London analysts believe the fall in prices will boost households’ after-inflation disposable incomes and help boost GDP growth. “Low inflation will provide a substantial boost to activity in the economy” according to Martin Beck of the EY ITEM Club. Another beneficial side-effect of low inflation is that it helps the Government balance the books. The Office for Budget Responsibility, the Government’s fiscal watchdog, cut its forecasts for UK borrowing over the coming years largely on the back of lower interest payments. Yet there are potential economic problems too that could arise from falling prices.



What are the problems?

The danger, in a nutshell, is that a period of falling prices will clog the arteries of the economy. Households could delay big-ticket discretionary purchases of consumer goods such as sofas and cars in the belief that prices will go down the longer they wait. It means employers, fearing lower demand for their products, could keep a squeeze on their workers’ wages. This could create a self-reinforcing downward spiral of prices. Low inflation would also end up making it more difficult for households, companies and the government to service their debts. In inflation-adjusted terms borrowers would see the value of their debts increase – another factor that could make them less likely to spend. This can be loosely characterised as “bad deflation”. Japan has been suffering from this kind of economic illness for the best part of 20 years.

How serious is the risk of “bad deflation” in the UK?

Economists are mostly sanguine. Michael Saunders of Citi noted that consumer confidence surveys showed the share of people who believe it is now a good time to make major purchases rose to the highest since 2007 in February. “There is no sign that UK consumers are reacting to declines on consumer goods prices by delaying purchases: the opposite is the case, with falling prices spurring increases in confidence and purchases” he said. Measures of financial market inflation expectations have moderated in recent months. For households they have also come down. But in both cases the declines have been pretty modest. Official forecasters such as the Bank of England and the OBR do not expect deflation to become entrenched.

Yet deflation for the UK would be unchartered territory. It is possible that it might be harder to escape than many expect, especially with large parts of Europe battling the same problem. It was notable that so-called core inflation – which strips out volatile items such as oil, food and alcohol – ticked down in February to 1.2 per cent, down from 1.4 per cent in the previous month. The consensus from City economists was for inflation to fall to 0.1 per cent, rather than zero, in February. The Bank of England made the same estimate earlier this year. One month’s overestimate does not matter too much. But more downside misses over the coming months will prompt a lot of analysts to start sweating.