In the UK, CPI inflation has fallen to 0%. Is this a cause for celebration or a cause for concern?
Firstly the government set an inflation target of CPI 2% +/-1 for good reasons. The fear is that if inflation is too low, we may start to get problems associated with deflation. More details here About the problems of deflation. But a quick summary:
- Rising real value of debt. With low inflation, it becomes harder than expected for people to pay back their debts – they have to spend a higher % of income on debt repayment leaving less income for other spending.
- Rising real interest rates. The fall in inflation increases real interest rates, whether we like it or not. Rising real interest rates make it less attractive to borrow and invest; it encourages consumers to save. If the economy is depressed, this rise in real interest rates can make monetary policy less effective in encouraging growth.
- Falling prices can encourage people to delay buying expensive luxury goods – they feel they need to wait a year because prices will be lower.
- Low inflation is an indication of low growth. A normal period of economic growth would typically give a moderate rate of inflation (2%). If inflation has fallen to 0%, it suggests that there is intense price pressure to encourage spending and the recovery is very fragile.
We have to look at the reason why inflation has fallen. At least part of the fall in UK inflation is due to temporary short term factors, such as falling oil and petrol prices. These temporary factors are unlikely to continue, and could be reversed. It is more important to look at underlying inflationary pressures – core inflation, which excludes volatile prices like food and oil. For example, other measures of inflation like – RPI is 1% (even though RPI is not the same as core inflation.)
Falling prices could boost real incomes. One of the fears of deflation is that it depresses consumer spending. However, with a fall in the price of basic necessities like petrol and food, consumers find their discretionary income / spending power has increased, this could actually lead to higher spending in the short-term. Continue Reading →