Deflation: What it means for you.

By Melanie Powell, Senior Lecturer Economics University of Derby, Derby Business School

Deflation is the latest worry. Japan has it, Europe has it, but do we? No. Not yet. But we are on the brink with the announcement that the UK inflation rate is zero. Will we catch it? Should we be worried? Surely inflation was the problem and so deflation must be good? It all depends.

Most of us have got our heads round inflation – rising prices, and understand why inflation can be bad for us. If prices rise faster than wages, we feel worse off because we can’t buy the same amount of goods and services. If prices rise too fast, it is hard for small businesses to plan and meet costs. If prices rise faster than interest rates, our savings are worth less and less. A little bit of inflation is good because it is the sign of an expanding economy, with all the benefits of high employment, expanding tax revenue and good times. UK inflation has been as high as 5% in recent years and months it has been falling steadily – disinflation. If it continues we will have deflation. To see if there is a problem, it is worth looking at the way it is calculated.

The rate of inflation is measured using the Consumer Price Index (CPI). Every month, the Government records the current price of items in a typical ‘basket’ of goods services. When the basket was first used in 1947 it contained only 150 items including household staples such as bread, tea, milk and petrol. These are still in the basket, but it is now bulging with over 700 items in 12 sectors: Food and non-alcoholic drinks; alcohol and tobacco; clothing and footwear; household water, electricity, gas and fuel; household furniture and equipment; health; transport; communication; recreation and culture; education; restaurants and hotels; and other goods and services. Each month, some of the items rise in price and some fall. The Government averages the price changes across all the items, taking into account how important they are in household spending. Food and non-alcoholic drinks, and household water, electricity, gas and fuel are more important. If the price average for this month is 0.5% higher than it was 12 months ago, the annual inflation rate is 0.5%. A positive percentage change is inflation and a negative percentage change is deflation – at 0%, we have neither.

The recent slowdown in inflation, disinflation, is clearly affected by falling oil prices. Fuel prices fell 16.6% over the 12 months to February this year, and electricity and gas prices fell 2.4%. Falling energy prices cut production and transport costs which slow inflation. We also import many goods from Europe, so as the pound gains strength against the euro, imports get cheaper. Overall the price of goods in the UK fell 2% over the last year. Our overall inflation rate fell to 0% in February as price falls in food and drinks, energy, furniture, books, toys and computer kit outweighed price rises in alcohol and tobacco, clothing and communications. So if these falling prices continue to counteract any rising prices, the change in UK prices will become negative and like Japan and much of Europe, we will experience deflation.

The Bank of England said in February that it expects the UK to experience negative inflation in the next few months but that it will be short lived. We don’t have deflation, we are not like the Europeans or the Japanese. Isn’t negative inflation just deflation? Yes it is, but the Bank of England wants to distinguish between a bad situation – embedded deflation – and a good situation – temporary deflation, which they call negative inflation.

So how will deflation feel to you and me when it appeared? It will feel a bit like disinflation but more so. Disinflation has felt good for most of us, but just like inflation, some of us noticed the effect more than others. If you drive a lot and fuel costs are a large proportion of your monthly income, you will certainly have felt good over the last year. The16% fall in fuel prices will have boosted your spending power and given you enough for some extra trips to your favourite restaurant, the cinema, or a weekend break. If you have to pay electricity and gas bills and buy the family food, you should also feel a bit better off. But if you smoke or drink alcohol, buy a lot of clothes or rely on the service sector you might feel a bit worse off. Maybe younger people might not feel the benefit of recent disinflation as much as others.

How you experience the effect of recent deflation also depends on whether your income kept pace with the positive inflation rates last year. If you had no pay rise at all and no increase in benefits, you might still have felt better off if you are a heavy fuel user. If you are living on a State pension, you might have felt better off with a pension increase above inflation of 2.5% under the triple guarantee, but you may be a heavy user of the more costly service sector and you might not have noticed the benefit of falling fuel prices if you don’t drive a car. If your income increased above inflation, you will be better off overall.

The initial effect of deflation will feel good for most. As some prices will still be rising, only those with static income, buying rising price goods will feel worse off. For the rest of us, the real wage – the money wage minus inflation – will be rising. If we spend the bonus in the UK, we will boost growth in the local, regional and national economy and eventually prices will stop falling and start rising again as growth expands. This is good deflation – falling prices result from the fall in supply costs rather than a too little domestic demand. Prices will stop falling when the drivers of falling supply costs, low oil prices and commodity prices stop falling.

So should we be worried? Will our good deflation develop into bad deflation? Bad deflation is caused by lack of demand for goods and services. If deflation continues and real wage don’t rise, we may expect falling prices and put off buying big household items, waiting for lower prices. The economy could get into a deflationary spiral causing recession. This is what Japan and Europe fear. There are few signs of this at present in the UK economy. Real wages are starting to rise, employment is rising, oil prices have stabilised and prices in the service sector, 80% of the UK economy, are still rising. The Bank of England, and many economists, think inflation will return later in the year. So enjoy deflation while it lasts.

Leave a Reply