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KPMG Enterprise

What is deflation and should we fear it?

Bill Robinson, Chief Economist at KPMG explains the January inflation results

The UK is faced with the prospect of deflation for the first time since 1960 – when John F Kennedy was running for the American presidency and The Beatles were just starting to make a name for themselves in a tiny Hamburg nightclub.

Today, the big news story is that prices are falling in the economy. In essence, this is what deflation is.

Inflation has been helped down by falling oil prices, with  US shale oil creating an excess supply that the Saudi Arabians are no longer prepared to offset by cutting back their own output, instigating a price drop of over 50%, from over $100 to below $50.

  • Benefits to the UK economy

Closer to home, falling food prices – reflecting global over-supply and lower prices of agricultural commodities – have left everyone feeling a little bit better off. So if it costs less to fuel our cars and ourselves, what’s the problem with deflation?

Well, there’s no serious problem yet but with prices dropping across the board, the real issue will arise if wages follow suit. At the moment, wages are actually rising – albeit rather slowly. So for now, with wages rising and prices stable or falling, our money is going further, the volume of consumption is going up and economic activity is gathering pace.

  • Why deflation could be bad news

The danger comes when people start to assume falling prices – not just of essentials like food, petrol and utilities but of big purchases such as cars, kitchens, carpets.

Once a deflationary psychology takes hold, so everyone expects things to be cheaper next month, and there is a strong incentive to delay spending. The result is lower consumption, a slowing of economic activity and an eventual loss of jobs. For business owners up and down the country, long-lasting deflation is a frightening prospect.

  • “Good” and “bad” deflation

From January to February, inflation was down from 0.5% to just 0.3% – the slowest pace since records began for the consumer prices index in 1989.

Mark Carney – governor of the Bank of England – has been quick to dispel fears of “bad” deflation, claiming 68% of the underlying categories of the Consumer Price Index (CPI) are actually rising in price.

However, it’s the drastic fall in the price of oil, energy and food that’s having such a huge impact. In other industries, prices are rising more-or-less in line with real household income. With unemployment falling, labour market conditions mean that wage inflation is actually more likely to rise than fall or stagnate.

  • The pound and the euro

The Eurozone has already experienced widespread deflation, with prices down by 0.6% compared with last year. This oil-driven price drop has freed up cash for consumers, helping along the convalescent European economies. France’s consumer spending is up 1.5% by volume.

The Eurozone has responded to deflation with quantitative easing, which has weakened the Euro and made it cheaper to import from the continent. This will further boost consumption, by cutting the price of our imports, but at the same time the growing value of the pound could price UK businesses out of the continental trade. On balance, the net effect is likely to be positive for UK output and employment.

So, if the UK economy does enjoy a brief period of falling prices – as many financial experts are predicting – the official view is that it will be temporary.

When the effect of the current fall in oil, energy and food prices drops out of the index a year from now, inflation will rebound.

So don’t defer consumption. Get down to the shops and snap up the bargains while stocks last!

Attached Files


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