Deflation: What's in Store?

Everyone likes to treat themselves to a little something now and again and one such way to do this is with some chocolate. Gone are the days when you could buy a Freddo bar with your spare change of 10p since its current price is now a huge (well, relatively) 20p.

This price rise, not sudden I hasten to add, is inflation in action. Inflation is a persistent increase in the level of prices and we measure what level inflation is at by comparing prices to the same month the year before. And not just any old prices are measured either, the Office of National Statistics has its own ‘basket of goods’ of about 600 different goods and services which are used for this comparison.

The target rate of inflation set by the Bank of England currently stands at 2.0%. This is also the same for many other central banks. This particular rate ensures that there is just enough economic growth and thus paves the way towards a ‘Goldilocks economy’.

However not all inflation is positive. We can also get deflation which is negative inflation. This has already set in, in the Eurozone and is a threat looming on the horizon for the UK.

Just to clarify; low inflation is not the same as deflation!

What causes deflation?

Deflation is caused by the supply of goods being higher than demand. We currently have a glut of crude oil in the markets. As a result the price of this commodity is very low. This then links to our energy bills being lower and it's also cheaper to fill up your car with petrol at the pump. This is also know as a positive supply shock as markets are able to provide goods to consumers at lower prices.

A price war is taking place between Britain’s major supermarkets as they compete for customers, slashing prices in order to look more attractive. Falling food prices have also contributed to inflation becoming lower and reaching its current rate of 0.5%.

The Pros & the Cons

The effect of deflation on consumers is one very similar to a tax cut. However this is only really the case in the short term. Once consumer prices start falling it is likely that wages will follow suit, ending that feel-good feeling. This feeling comes from groceries and fuel costing proportionately less which then leaves more disposable income to spend on other things. People feel richer.

Deflation, by its very definition, means that prices are falling. A person might hold off on buying an elastic/luxury good e.g. a new television right now, if they feel that it’ll be cheaper fairly soon. Durable goods e.g. cars and computers are also particularly affected because they'll last for a long time. Consumers have this future expectation that prices will continue to fall so they put off spending.

People are also more reluctant to spend because low inflation increases the real burden of debts i.e. the cost of repayments gets higher. This is because the amount that is needed to be paid is fixed  (regardless of the rate of inflation) whereas the earnings of the those in debt may actually decrease. 

The main aim of firms is to maximise profits. Companies will consider cutting prices and maybe even make some workers redundant just to ensure that they still get their profits. This cutting of prices only worsens deflation further.

What can we do about it?

Right now in the UK we are experiencing very low inflation, the lowest levels seen in decades. The possibility of sinking into deflation, i.e. negative rates of inflation, is very real.

Normally interest rates are used to influence consumer spending - the lower the interest rate, the greater the incentive to spend.

However this may not always be such a good solution. The nominal rate of interest cannot go below zero, thus rendering this kind of monetary policy ineffective. If interest rates cannot be reduced further AND inflation is low then demand will further weaken. This dilemma is also known as the deflation trap. Also, if there is low consumer confidence people may anyway be more inclined to save rather than spend, due to the negative future expectations, regardless of the interest rate.

Another method which can be used to combat deflation is by using quantitative easing. This has recently been implemented by Mario Draghi (President of the European Central Bank) in order to deal with the Eurozone deflation. This money is used to buy up government bonds from the 19 Eurozone nations. Interest rates are already quite low in the UK at 0.5% and it has been at this level since March 2009. 

Hence a better policy for the UK might be quantitative easing. This is a policy that has been implemented in the UK long before it began in the Eurozone. There have been positive reports of QE being ‘economically significant’; £200 billion worth of bonds bought between March and November 2009 led to an increase in economic output from 1.5 – 2%.

EDIT: 20/02/15

The rate of inflation in the UK is now 0.3%, one of the lowest levels it has ever been at. After reading this week's issue of the Economist I felt there were some further key points which would be useful to add.

Risk of further deflation is also present, coming from a large (economic) slowdown in China etc (Monetary) policymakers have hardly any room for manoeuvre i.e. in many countries the interest rate cannot be reduced further.

It is also suggested that it is best to set a completely new target - aiming for a particular level of  nominal GDP. GDP is the total value of spending in an economy and the 'nominal' part means that it is adjusted for inflation. Therefore we would not be so affected by price shocks.