UK Inflation Falls To 0.5% Giving The Bank Of England A Serious Problem


SHAFAQNA – Given the monetary history of the past 70 years or so it’s a bit of a surprise for the UK to be facing an inflation rate that is possibly too low. But that’s the problem that the Bank of England faces as it is announced that the UK inflation rate has fallen to only 0.5%. It’s expected to go negative (ie, a fall in the general price level) over the next few months and that’s not really what anyone wants. The dilemma really becomes, well, what is it driving that deflation? Or even, is it really deflation at all? If it is, we don’t want it and action must be taken.

The news itself is here:

Lower oil and food prices have pushed UK inflation down to 0.5 per cent, its lowest level for nearly 15 years, weakening sterling and trimming bond yields.

The official figure for consumer price inflation in the year to December was half the 1 per cent recorded in November and should provide a boost to household finances that have yet to see a sustained rise in wages.

There’s most definitely good things happening here. That rise in real wages is one of them. The last numbers for nominal wages were a rise of just under 2%, meaning that with a 0.5% inflation rate we’re seeing some real rises. Given that that’s the very point of having an economy, making the populace richer over time, of course this is good news.


But the possibility of deflation hitting developed markets is sending yields lower and after the inflation data were released the five-year UK gilts fell below 1 per cent, hitting their lowest level since May 2013, down 4 basis points on the day to 0.97 per cent. Sterling also fell, reaching a session low of $1.5083, having been trading at $1.5119 immediately beforehand.

Weak inflation was traditionally a big concern for central banks who feared a prolonged period would alter consumer expectations and lead to a vicious circle whereby consumers delay spending while they wait for prices to fall and expectations of low inflation make it easier for firms to award weak pay deals.

There’s really two separate problems with very low or negative inflation. With true deflation the tendency is for it to shrink the economy. The value of outputs, if all prices are falling, obviously falls. But the debts that must be taken out to produce their creation do not fall in value. Thus there’s a tendency for there to be a reduction in investment. Further, if everything is going to be cheaper tomorrow then why buy today? This again slows economic growth. A general deflation in a debt driven economy is therefore considered to be a not very good idea.

There’s also a problem that spills over into low inflation rates. We’re obviously delighted that some prices do fall. Ever cheaper computers is not regarded as a major problem for example. That the wages of certain types of worker fall relative to others is just evidence of the market reallocating labour and so on. But as Keynes pointed out, people really hate to see their nominal incomes fall while being much more sanguine about real incomes falling if nominal ones at least stay static. Thus we’d like a little bit of inflation (say, around 2%) in order to cover those useful and desirable changes in real prices while allowing nominal ones to perhaps stay static.

So, a little inflation is perhaps desirable and deflation is undesirable. But falling prices are not undesirable: and therein lies the policy problem. Which is it that we’ve got here? Just some prices falling or real deflation?

We would hesitate to term this a period of deflation, as we consider deflation to be a sustained period of widespread falling prices, and not a few months where energy costs drop sharply. Note from today’s data that despite the sharp downward trajectory of the headline rate of inflation, the ‘core’ measure (i.e. CPI ex-food, energy, tobacco and alcoholic beverages) actually ticked up a touch to 1.3% from 1.2%.

That’s encouraging but not final. For do recall that this is macroeconomics we’re talking about here, the bit of economics that we’re really not sure we’ve got quite right as yet. And we’re pretty sure that at least parts of the eurozone are in real deflation, so there’s no reason to think that it cannot happen here.


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