Woooooooo!
That’s the spooky sound of the deflation bogeyman, haunting the corridors of the Bank of England. The latest data shows that prices are falling in the UK, something that central banks hate.
It doesn’t sound very scary. And at first sight, it isn’t really.
But in the long run, entrenched deflation could be a real problem. Let’s just hope it doesn’t get to that…
How scary are falling prices really?
Inflation in Britain hit -0.1% in April. In other words, prices – as measured by the consumer prices index (CPI) – fell by 0.1% over the past year. That’s the lowest level since 1960, as the papers keep repeating.
If you use the once-popular retail prices index (RPI), it’s still pretty low – 0.9%. That’s the lowest since the financial crisis (when RPI fell hard, but CPI stayed positive), and before that, 2001. So not as dramatic, but still a very low reading.
(You can also argue the toss about definitions. Deflation and inflation in the money supply, as opposed to price changes, are very important. But this morning we’re talking about prices.)
Why are prices falling? The fact that Easter was later this year than last means that prices for flights and ferries fell rather than rose. That’s purely a seasonal thing, and without that, inflation would probably be flat.
However, the recent fall in the oil price (now reversing rather) is still pushing fuel and energy bills down. The cost of food is generally falling too, and price wars between supermarkets desperately competing for market share are keeping a lid on prices too.
So the cost of feeding yourself and staying warm is falling. Meanwhile, employment is high, wages are gently recovering, and if your savings account pays any interest at all, then you’re actually getting a ‘real’ return on your money.
What a terrible, terrible world, eh? You could be forgiven for wondering why deflation is such a bad thing. And you’ll hear some frankly stupid explanations for why falling prices are bad.
The classic one you see trotted out is that consumers will put off making purchases. But prices fall in all sorts of industries all the time. It doesn’t prevent people from rushing out to snap up Apple’s latest smartphone every time a new one comes out.
A more reasonable point is that falling prices might reflect the fact that companies can’t sell goods due to low demand from consumers. But that’s not the case just now. Low prices – in sectors where prices are falling – instead reflect intense competition or over-capacity in the likes of the supermarket sector.
The real problem with deflation
The best plain English explanation of the real problem with deflation that I’ve ever seen came from my colleague Merryn in a recent blog.
Most of us have grown up assuming that inflation is the natural state of things, particularly in the UK. (Before the 20th century, that wasn’t at all the case, but in all of our lifespans, it has been.)
So when we make decisions about borrowing big sums of money – which for most of us, involves buying a house – there’s an implicit assumption that £100,000 today won’t be worth anything like that in 25 years’ time.
We’re used to the idea that inflation will erode our debts and ultimately amplify our wealth over the long run. So we over-borrow – or at least we borrow as much as we can take on. As Merryn puts it in her blog, “borrow big and inflation will make you rich”.
If that changes, then even although deflation might be mild and your wages might even keep up with price changes, the trouble is that the huge mortgage you took on in your early 30s will still be a huge mortgage come your early 50s. And that weight of debt will continue to depress your overall spending power – and therefore your propensity to spend – too.
“That’s why deflation matters to a deeply indebted society in a way that it just doesn’t to a solvent one. It’s all about psychology.”
So far deflation isn’t looking like a problem for the UK
Anyway, the good news is that, so far, we probably don’t have to worry too much about deflation – not in the UK anyway. Lower petrol prices? Bring it on. With the oil price rebounding it’s probably not going to last, and any money not spent on petrol just contributes to consumer demand anyway – so it actually puts more money in our pockets, not less.
Supermarket wars? Same again. Moreover, that’s a positive, technology-driven change – and haven’t we all been bemoaning the demise of the high street in favour of out-of-town retail wastelands? Here’s your solution, brought to you courtesy of the free market.
Capital Economics has the optimistic take on things. Assuming the oil price rally doesn’t pick up steam, then inflation should remain “comfortably below” the Bank of England’s 2% target rate for a while. That means consumer spending power will have time to recover, and the overall economic recovery should be able to continue – even in the face of potentially big government spending cuts.
That’s the optimistic take, and for now I’d agree with it. But this is something that we’ll be discussing in a lot of detail at our conference on 12 June – if you haven’t got a seat yet, check out the details here.
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