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The Challenge of Deflation

Inflation in the UK has fallen substantially in recent months. Using the consumer price index, which is the measure targeted by the Bank of England, it fell from a peak of 5.2 per cent in September last year to 3.1 per cent in December.

The fall in retail price inflation was even sharper. It peaked at 5.0 per cent in July and again in September, but by December it was down to just 0.9 per cent.

A large gap has opened up between the two measures of inflation because of the different way they treat housing costs. The consumer price index does not include any estimate of the cost of owning a home. The retail price index does, and it is based on an estimate of average mortgage interest payments. The Bank of England’s decision to cut the official bank rate from 5 per cent in September to 2 per cent in December led to lower mortgage rates. As a result, the Office for National Statistics estimates that the average mortgage interest payment fell by 24 per cent between September and December. This had the effect of reducing the price level and the inflation rate, as measured by the retail prices index, by 1.5 percentage points.

Inflation seems certain to fall further, on both measures, in 2009. The economy is in recession and weak demand and output are usually associated with falling price pressures. True, the depreciation of sterling over the last year might be expected to push up the price of imports but companies will find it hard to make price increases stick in the present climate.

There are also several special factors to be taken into account. Petrol prices have already fallen about a quarter from their peak, reflecting the fall in crude oil prices. But energy companies are only just beginning to announce cuts in gas and electricity prices. (These respond with a lag to movements in crude oil and natural gas prices because energy companies tend to buy their supplies well in advance.) Food price inflation, which is still running in excess of 10 per cent, is likely to fall back to a more normal level reflecting movements in global commodity prices. And the cut in the main rate of VAT, from 17½ per cent to 15 per cent, which came in effect on 1st December last year, will lower inflation by about 1 percentage point from December last year through to November this year.

All these factors will bring down both consumer price and retail price inflation. In addition, the Bank of England reduced the bank rate further to 1.5 per cent in January, which will lead to another cut in mortgage interest payments and another drop in retail price inflation (and there may be more rate cuts to come).

We will find out how the Bank of England expects inflation to develop when it releases its latest Inflation Report later this month but a clue was provided by the Governor, Mervyn King, in his open letter to the Chancellor last December. He said that he expected consumer price inflation to ‘move materially below [2 per cent] later in the year’ and warned that it is ‘quite possible’ that it would fall to below 1 per cent.

Given the gap that has opened up between consumer price and retail price inflation, this could mean inflation turning negative on the retail price measure for the first time since 1960.

Economists worry that deflation (negative inflation) will lead to consumers postponing purchases, in the hope of being able to buy things cheaper in the future, which would deepen and extend the recession. That is unlikely to occur in 2009 (although that will not stop the recession being a serious one for other reasons). First, deflation will, in part, reflect the temporary cut in VAT, which only extends until the end of the year. If anything, there will be an incentive to buy things towards the end of the year, before the rate rises back to 17½ per cent. Second, deflation will reflect falling energy prices and we cannot postpone our use of gas and electricity, whatever we think might happen to the price. Third, deflation will reflect lower mortgage interest rates, which are designed to support the housing market. More generally, we are now used to deflation. Prices of electrical goods, clothing and footwear have been falling consistently for several years but we have not stopped buying mobile phones, shirts and dresses.

Negative inflation will, though, present a particular political challenge for the Government.

The September rate of retail price inflation is particularly important because it is the rate used to index the State pension and other welfare benefits annually. As a result of last year’s jump in inflation, these are being increased by 5.0 per cent in 2009 (that is in line with the rate of inflation in September 2008). However, suppose retail price inflation is -1 per cent in September 2009, which, to borrow Mervyn King’s phrase, is ‘quite possible’. Will the Government cut the State pension and benefit rates in 2010? That would appear most unlikely. But how much will they choose to increase them by in view of the pressure to control the growth in public spending?

There was much criticism of the Government in 2000 when the State pension was only increased by 75p (due to a low 1.1 per cent rate of retail price inflation in September 1999). The likely path of inflation in coming months means that a similar problem might be ahead for the Government later this year.

Increasing benefits by, say, a minimum 2 per cent would alleviate hardship amongst some of the most vulnerable sections of society, boost their spending power and so encourage consumer spending. This would help to counter the recessionary forces in the economy.

Visit eGov and review the original article by Tony Dolphin, Senior Economist, IPPR