Deflation forecast first for 50 years

The Bank of England is heading into uncharted territory next year as policymakers face up to the UK's first bout of deflation in nearly 50 years.

The Bank's forecasts are set to show inflation tumbling during 2009 as oil and energy costs shift lower in the latest twist of a turbulent ride for prices.

The Consumer Prices Index - currently at 5.2 per cent - has been a headache for rate-setters throughout 2008 but is likely to plunge to 1 per cent or less next year.

Experts say the official measure of inflation could even turn negative for the first time since 1960 - the year John F Kennedy won the race to become US president.

Shoppers coping with the rampant inflation of the past six months could be forgiven for welcoming the potential boost to the pound in their pocket.

But they may not be so keen on the prospect of falling wages while saddled with the burden of debts piled up in the good times.

The one silver lining for homeowners with inflation was that the value of their big debts such as mortgages was eaten away more quickly.

With deflation the opposite is the case. A prolonged bout can lead to businesses and consumers deferring spending amid expectations that prices fall further still.

Benefit payments such as the state pension are also pegged to the cost of living. While this stood at 5.2 per cent in September, a period of deflation next year could herald much smaller increases for millions of people.

And the impact of a severe recession on prices could spark a prolonged period of deflation to match that seen by countries such as Japan, economists warn.

The volatile path of inflation in the past 18 months - and its likely descent over the year ahead - was unprecedented during the whole of the Bank's first decade of independence.

Governor Mervyn King has to write a letter of explanation to the Chancellor whenever CPI rises or falls more than 1 per cent above its 2 per cent target.

It was nearly 10 years before any Governor had to write such a letter - in March last year - after an early spike in oil and energy costs.

CPI was below target within six months as lower energy bills took effect, although this was a brief respite as oil hit 147 dollars a barrel and two rounds of gas and electricity price hikes sent it spiralling higher again.

The prospect of several letters on the way up - two so far and a third due next month - is now matched by the possibility of more missives on the way down late next year as energy and commodity prices slide and demand falls in a recession.

The all-time low for the CPI was 0.5 per cent in May 2000, although at the time the Bank's Monetary Policy Committee was tracking the more inclusive Retail Prices Index, then reflecting rising house prices.

Capital Economics' chief European economist Jonathan Loynes, said: "The forces that have lifted UK inflation sharply higher over the last year or so are now set to work strongly in the opposite direction."

There is now a "good chance" that CPI inflation turns briefly negative in around a year before the deflationary effects of falling food and energy prices start to fade, he added.

RPI - which includes items such as mortgage interest payments - could hit around -2 per cent as banks eventually pass on lower repayments, Capital Economics said.

Coupled with the steadily growing chances of a deep recession, the prospects for the UK economy look bleak.

"There is a clear danger that the huge amounts of spare capacity created by the recession prompt a more prolonged period of falling prices further ahead which threatens to turn into a Japanese-style deflationary spiral," Mr Loynes said.