The rate of inflation has turned negative for the first time in 55 years in the UK. The phenomenon of deflation in economic jargon means consumers will see a drop in prices, with essentials like petrol and food cheaper than this time a year ago. Crucially, deflation constitutes a fall in prices over a sustained period of time. This can be a very serious economic problem and one which it is not easy to cure. So should the UK be worried?
The clearest example of deflation in the modern era is Japan, which has been struggling with long periods of falling prices since the 1990s. This has been associated with very low, and even negative, economic growth over an extended period. While poor economic policy has been partly to blame, it has illustrated very well how stubborn the problem can be.
The deflationary spiral
Why? The key problem relates to debt. Once it takes a hold, deflation leads not just to falling prices but also falling wages. The fact that the contents of the weekly shopping basket are getting cheaper provides a cushion to falling wages. But one thing that does not fall in a deflationary period is the amount of money we owe.
The further wages fall, the more difficult it becomes to pay our debts, squeezing household budgets, which depresses spending and creates further downward pressure on wages and prices. Some loans will go bad, weakening the financial system.
What is more, there can be pernicious effects on consumer psychology. Falling wages damage consumer confidence and falling prices can lead consumers to postpone purchases – again depressing spending and economic activity. Finally, it becomes harder to use lower interest rates to boost the economy, particularly when interest rates are close to zero, as they are in the UK. This is known as the deflationary spiral.
Keep calm and carry on
This all sounds rather gloomy, but there is no real need to worry about the nightmare scenario of deflation in the UK. The lesson of history shows that before World War II, periods of falling prices were not unusual and, with the exception of the Great Depression of the 1930s, they were not really associated with economic damage.
It is the past 55 years which have been rather exceptional in terms of an almost unbroken sequence of prices rising month on month, not falling prices. In fact, the fall in prices we are seeing now has clear causes due to the very steep fall in the price of oil (most consumers will have noticed it is now much cheaper to fill up with petrol) and, to a lesser extent, falls in food and energy prices. The fall in prices is not occurring across the board, even though oil, food and energy are important elements in household budgets. It is also very unlikely to be sustained, ash oil prices are already on the rise.
Pay is rising too. This is not least because unemployment has been falling rapidly and demand for labour is growing, reflecting the return to more normal levels of economic growth in the UK. The economy is working much closer to full capacity than it did in the financial crisis.
Therefore there is pressure for prices to rise, though they will do so only slowly. Should it look like there is any prospect of deflation, the Bank of England will act, cutting interest rates a little (though there is not much further to fall from 0.5%) and pumping money into the economy – so-called quantitative easing. The UK also has a floating exchange rate and it is highly unusual for an economy with both a floating exchange rate and an independent central bank to experience deflation.
In the 1980s, the then chancellor, Nigel Lawson, famously dismissed a jump in the rate of inflation as merely a “blip”, only for the economy to turn sour and overheat. I am prepared to put my neck on the chopping block and predict that the fall in prices will be only a blip which will be reversed by the end of the year. So keep calm, carry on and enjoy the falling prices while they last.