Make the most of a brief deflation induced mini boom

We now have deflation in the UK – a situation where the Consumer Prices Index – the main measure of inflation – has turned negative at minus 0.1%. While the statistical base has changed, you’d have to look back to 1960 for when this last happened. The rate has been driven down by the impact of lower energy and food prices, boosted by low air and other fares as the impact of lower fuel costs feeds through to the market.

It now seems there is good and bad deflation. UK deflation is of the good variety, while that in eurozone economies is bad. The difference is that UK deflation is underpinned by continuing economic growth, but that’s not the case in many eurozone countries.

In the UK, deflation, particularly of food prices, is leading to a mini boom in consumer spending. Wages are rising slightly as the economy improves but ‘spending power’ is rising more strongly as the fall in the inflation makes people feel better off and more ready to spend. That helps grow the economy and create conditions for wages to rise again, building an upwards economic spiral. Bad deflation is when prices are falling and there’s no underpinning economic growth. Then people hold off making major purchases believing prices will fall further, driving the economy in a downward spiral.

Reading what the analysts say about events in the UK, there are no concerns about that happening. They see delivery of a negative inflation figure by the Office for National Statistics as interesting, rather than a long-term threat to the economy, partly because the other measure of inflation, the Retail Prices Index, is still positive at 0.9%.

It seems strange that the Governor of the Bank of England will now have to write to the Chancellor to explain why inflation is below the 2% target, after a long time when he and his predecessor had to justify the figure remaining above that target.

Relatively high inflation (up to 3%) and low interest rates helped eat away the real value of debts, but we’re now in a situation that’s better for savers than borrowers, as even modest returns on savings are finally above the inflation rate. This is not, however, a situation that will last. The inflation rate measures year-on-year change, and nobody could have forecast a year ago how great the fall in energy costs would be, or the collapse in profitability of major UK supermarkets that has driven a food price war. As well as lower global commodity prices, this has driven food price deflation and food and energy costs are big-ticket items in the inflation calculation.

The expectation is that this will be a brief phenomenon. The Bank of England suggests inflation will rise in the latter part of the year, and by the end of 2015 or the start of next year will be moving back towards 2%. This confirms that economies are always cyclical. Better times and growth inevitably drive wage costs up. That drives inflation into the economy, so the cure for deflation becomes inflation, just as in farming the cure for low prices is low prices, which reduce production.

One reaction to the publication of the deflation figure was that shares rose while sterling faltered – probably because of fears that deflation might be a sign of looming eurozone-style problems. But sterling’s wobble was short-lived and with the UK economy sound, the expectation is that there’ll be little change in the euro:sterling relationship for some months. That’s good news for the UK economy, but less welcome news for farmers, who generally do better when a national currency is weak, since this boosts exports and heads off imports.

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