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Hargreaves Lansdown: Don’t panic – this isn’t ‘bad’ deflation

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Written by: Ben Brettell, senior economist, Hargreaves Lansdown
19/05/2015
Today’s news that inflation has turned negative is no surprise – although economists on average had forecast that inflation would remain at zero this month, a brief period of deflation this spring has been on the cards for some time now.

Seasonal factors were at work in this month’s figures – CPI inflation was pushed down by cheaper air fares relative to last year. Last year the Easter holiday, and associated higher fares, fell in the middle of April, whereas last year Easter was not included in April’s data.

Mere mention of the word deflation is usually enough to bring policymakers out in a cold sweat, but in this instance falling prices should not be cause for concern.

The experience of Japan over the past few decades illustrates why deflation is feared – if falling prices become entrenched in expectations, consumers and businesses defer spending decisions in anticipation of lower prices tomorrow and economic stagnation results. It is the threat of this scenario which promoted the European Central Bank to engage in quantitative easing. However, the situation in the UK is different for two main reasons.

Falling inflation has largely been driven by falling fuel and food costs, and this should be positive for the economy. When the price of essential goods and services falls it acts like a tax cut, boosting disposable incomes and allowing consumers to spend on other items. Mark Carney, the Governor of the Bank of England, has described the impact of cheaper oil prices as “unambiguously good” for the economy.

Also the current bout of deflation is almost certainly temporary, with the inflation rate due to rebound once the effect of lower fuel and food prices falls out of the year-on-year calculations. Inflation expectations among households are actually increasing.

Some members of the Bank of England’s Monetary Policy Committee have indicated they stand ready to cut interest rates if prices fall for a prolonged period. However, given that this looks unlikely, the next move in interest rates is almost certain to be upwards, although I can’t see them rising before mid-2016. Thereafter the process of raising rates is likely to be gradual, with the Bank mindful of high household debt levels (including mortgages) and the potential impact of a stronger pound.

 

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