Sustained deflation: is it good for the economy?

Everyone loves a bargain, whether they’re a high-street shopper or business purchasing manager. Falling prices are a boon for those with cash, but mention the word ‘deflation’ and the colour will drain from their faces. And with good reason. The odd price fall is a buying opportunity, but a widespread and consistent fall in prices – the definition of deflation – is a harbinger of grim economic times ahead.

Japan suffered deflation during its so-called ‘lost decade’ in the 1990s and may fall back into its cold embrace. In the US, prices fell around 30% between 1930 and 1932 – at a time when one in four Americans was out of work.

Deflation has now arrived in the UK. Official figures show prices of household goods and services failed to post any

annual increase in the year to February and actually fell 0.4% in the year to March – the first time the headline rate of inflation, the retail prices index (RPI), has been below zero since 1960.

It will get worse: the consensus forecast is for annual deflation of 2.1% this year, with one economist pencilling in a 3.7% decline, according to a Treasury survey.

Negative outlook
Sharp interest rate cuts have reduced mortgage payments dramatically, and falling house prices feed through to the index. Falling utility and food bills should still push it into negative territory before long, says Vicky Redwood, an economist at research consultancy Capital Economics. “The opening up of a large amount of spare capacity in the economy risks a broader and more persistent period of falling prices,” she says.

It is this “spare capacity” that helps explain the dramatic fall in RPI from +5.0% to -0.4% within the space of six months since September 2008. The UK economy will contract almost 4% this year, according to the International Monetary Fund, while growth in the money supply has dropped from 22% a year to just 10% over the same six-month period. These are vital ingredients for deflation.

The government is clearly aware of this danger. With official interest rates at 0.5%, the Bank of England has now embarked on quantitative easing – creating new money to offset the fall in money supply growth, using the proceeds to buy bonds to push down market interest rates. This may prevent a sustained drop in prices, but can do little to prevent the negative inflation over the coming months that many believe is in the pipeline. So what does deflation mean for consumers, businesses and investors?

Short-term windfall
For consumers, deflation is a short-term windfall as it means the prices of goods – jeans, jam and jasmine – are less than they were a year ago. The downside is three-fold. First, prices will be lower again in a year’s time making keeping one’s wallet or purse shut a rational decision. Second, as prices fall and consumers hold back from spending, businesses see turnover and profits fall.

This leads to the third bombshell – a fall in wages. This is already feeding through into the official statistics: private sector earnings slumped 1.1% over the year to January, the first decline for at least 18 years. The bad news for workers is that many pay deals are linked to RPI. Union leaders have warned against imposing pay freezes, saying it could lead to a deflationary spiral that could prolong the recession.

“While many workers in companies hit hard by the recession have agreed modest or no increase in pay to save their jobs, a generalised wage freeze across the economy will make the downturn worse, not better,” says Brendan Barber, secretary-general of the Trades Union Congress.

For those with debt, the position is worse. On average, every British adult currently owes £33,000, according to PricewaterhouseCoopers. For them, deflation means that, in nominal terms, £33,000 of debt will feel even more burdensome in a year’s time.

Poor state of affairs
More worrying for many households is that a range of state welfare and pensions benefits are officially linked to the RPI. While benefits cannot be cut even if RPI goes negative, vulnerable groups, such as the disabled, will see their payments frozen at current levels if RPI turns negative in September – the month of reckoning for benefits.

Pensioners will be better protected. After the uproar in 1999 when a drop in the RPI rate in September left pensioners with a meagre 75p increase in the state pension, the government promised that the basic pension would never rise by less than 2.5%.

But workers who have reached, or are near, retirement age – whether on a final salary or equity-based pension – will be forgiven for fretting a little. Those on a defined contribution scheme who have bought an index-linked annuity will see their payments fall as RPI falls. Those approaching retirement, who have already seen annuity values kiboshed by the slump in the stock market, may see annuity rates fall further thanks to deflation.

The dwindling band of pensioners on final salary schemes will be more protected, although their former employers will have to pick up some of the bill. Pension payments have to increase in line with a ‘limited price indexation’ (LPI) that uses RPI, but cannot reduce payments if the index goes negative.

While pension schemes cannot reduce payments, deflation will increase the real value of the liabilities. Deborah Cooper, head of retirement resource for Mercer’s pensions consultancy, estimates that at the end of February the LPI rules had increased company deficits across all FTSE-350 companies by £10bn. She says the pain for schemes would be accentuated by the drop in the value of index-linked gilts that many invest in as a hedge against inflation. “Under these scenarios, funding levels could fall under a sustained period of negative inflation,” Cooper says.

Under deflation, investors holding index-linked gilts suffer an absolute dro p in wealth. The Debt Management Office, the government’s bond agency, explains that negative inflation pushes down the value of the bond at redemption and the coupon payment, or interest. “In this way, the returns to the investor from holding index-linked gilts are maintained in real terms – as measured by the RPI,” it says.

Off-peak fair
One little-mourned loser will be the train operating companies whose right to endlessly hike certain ticket prices is linked to RPI. They are allowed to raise fares, such as season tickets and off-peak journeys, by 1% above RPI in July. So if prices fall more than 1% in July, the formula will trigger automatic cuts in thousands of regulated fares.

Companies may see their business rates bill cut in line with any fall in RPI in September. Last September’s 5% inflation would have meant a 5% hike in rates if ministers had not backed down and cut it to 2%.

But whether you are a winner or a loser from deflation, sustained falls in prices are bad news for the economy, as Japan’s stagnation shows. The $3.5 trillion that governments worldwide will have poured into the economy by the end of next year should avert deflation and depression. So at some point inflation will be back, perhaps with a vengeance. We haven’t said RIP to the RPI.

For more on Quantitative easing, click here.