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UK inflation is negative again, but what does this mean for consumers?
‘Households are getting a considerable boost to their spending power due to the fall in the prices of petrol utilities and food.’ Photograph: David Levenson/Alamy
For the second month running the UK’s headline figure for inflation – the rate of increase in prices for goods and services – is negative. In October, prices were 0.1% lower than a year ago – the first time ever that the consumer prices index (CPI) has fallen in two consecutive months.
While September’s figure is used to determine benefits rises, October’s is not so important in that respect. But the rate of inflation could still have an impact on your finances.
For consumers, the fact that prices are not rising may seem like a good thing at first glance, but the low inflation environment has implications that make the story less straightforward.
The wider economy
Opinion is split among economists as to the causes of this deflation and its implications for the economy. Paul Hollingsworth, UK economist at consultancy Capital Economics. believes this is a temporary blip. “We doubt that we are entering a new era of zeroflation or noflation,” he says. “Indeed, inflation looks set to pick up around the turn of the year as we reach the anniversary of previous sharp falls in oil prices.”
In the meantime, he takes the view that the mild deflation seen in recent months is essentially good, driven by lower energy prices, rather than symptomatic of weakness in the domestic economy. “It is good because it boosts households’ purchasing power and lowers firms’ day-to-day running costs,” he says. “At the moment, households are getting a considerable boost to their spending power due to the fall in the prices of petrol, utilities and food.”
In contrast, economist Professor Steve Keen from Kingston University believes even mild deflation is bad news. “Deflation is only benign — or even beneficial — in a world in which no one has any debt. Bizarrely, this is the world that conventional economists actually imagine we live in, since their models have ignored debt. With debt, deflation amplifies your indebtedness, which is what happened drastically during the Great Depression.”
Keen is convinced deflation will be here for decades, just like in Japan. And he predicts that we are headed for full-blown deflation if the government follows the path of austerity. “On current policy settings, I’d say it’s guaranteed, but it won’t be a runaway process,” he says. “Instead, it will taper to a level in the zero to -2% range. This again has been Japan’s experience. Some mild inflation has resulted whenever the government has run a fiscal stimulus, only to peter out back into deflation when the stimulus was removed.”
Both agree that a prolonged period of deflation would be bad news for the economy. Hollingsworth says it could alter households’ inflation expectations and persuade people to delay their spending in anticipation of lower prices in the future.
“It could also cause firms to become less certain about future profits, and so delay investment decisions, or cut nominal pay growth for workers to keep real pay constant,” he adds. “What’s more, it could also cause asset prices more generally to fall.”
Keen also stresses that with UK firms and households carrying a lot of debt (175% of gross domestic product), “households and firms will be reluctant to finance any new spending with new credit, so investment in particular will slow down as will economic growth”.
Winners and losers
The most immediate implication of continued deflation is that it makes an interest rate rise less likely – in the short term this is good news for borrowers, but not for savers.
But in a long-term deflationary environment, those carrying debt would find the real cost of servicing those debts increasing. Keen explains: “1% deflation on a 3% mortgage rate means you have to give 4% of your real income to the bank.”
This is likely to be compounded by increasing unemployment, particularly in sectors where pricing power is low, such as steel, or those that rely on discretionary consumer spending.
Even for those in work, incomes could drop given the pressure for cuts in wages and overtime as businesses seek to reduce costs to maintain profit margins in the face of falling demand and prices.
Of course, there will be some winners from deflation. Ann Pettifor, director at Prime Economics, says: “Disinflation or outright deflation benefits those on fixed incomes, as they’ll be able to buy more goods and services as prices fall.
“It is also good for creditors. This is because while price increases can fall below zero, effectively turning negative, interest rates for loans and mortgages cannot. So while wages or incomes may fall, interest rates (once they hit the 0% level) will effectively rise relative to these falls.”
Patrick Connolly, from financial adviser Chase de Vere, points out that deflation could be good news for savers. “Since interest rates were reduced to 0.5% in March 2009 savers have been faced with the prospect of earning paltry returns on their cash savings. However, while savers may feel disadvantaged in absolute terms, in a deflationary environment they are at least making money in real terms.”
But for those using their pension to buy an annuity, low inflation is bad news. “Annuity rates are determined by gilt yields and longevity,” says Connolly. “In a deflationary environment, the return offered by fixed interest, including gilts, become more attractive and so it is likely that prices will rise and yields will fall. This would be bad news for somebody looking to take out an annuity.”
What to do with your money
Broadly speaking, people should try and reduce their exposure to debt and maximise their cash savings.
Those with large mortgages in relation to the value of their properties should consider ways of reducing their debt ratio, perhaps by using savings to pay down the loan or downsizing their property. Alternatively, it may make sense to restructure the mortgage and any other loans by remortgaging. Kay Ingram, an independent financial adviser at LEBC, says: “Fixed rates are very low now and if you’re going to fix now is a good time to do so.”
Ingram says buy-to-let landlords should be especially mindful of the future cost of their debts in a scenario where house prices and rents may cease to increase year on year and may even fall. “Property investors who are not cash buyers need to be aware that a deflationary market will increase the illiquid nature of property investments, the time taken to sell and realise capital is likely to increase, so only those who can afford to wait to realise their investment can afford this risk.”
Stock market investors should also take particular care to avoid companies with excessive debts in a deflationary environment. For as demand falls so will their profits, leaving them vulnerable to banks calling in loans or refusing to increase them.
Kay Ingram from independent financial adviser LEBC, says falling prices and lower interest rates mean that investors who are interested in income are likely to find fixed-interest investments, corporate bonds and gilts are more attractive than cash. But she warns: “In part, though, the extra earned compared to cash will simply reflect the increased risk of default and so capital losses could increase if deflation is persistent.”
Singapore-based investment guru Jim Rogers says only stable bonds and cash will do well in deflation. “You have to be certain you are in the right currency and, if you buy bonds, hold sound bonds that will pay the interest and prinicipal. Government bonds are usually okay.”