Bad Inflation: Can the Momentum be Arrested?

Consumers are less inclined to part with their money on Monday when they believe they may be able to pick up a better deal on Tuesday.

The problem for the Bank of England is that rates already sit at a record low of just 0.5%, which doesn’t leave the governor a great deal of room for manoeuvre.

According to figures released by the Office for National Statistics on Tuesday, February saw CPI (Consumer Prices Index) inflation fall to 0%, down from 0.3% at the start of the year.

If this trend continues - and many expect it will - the rate is set to dip into negative figures at some point during the coming months, sparking fears of a deflation trap.

Coinciding with and driven by falling food costs and lower prices at the pump, you might be forgiven for assuming that a drop in inflation would be good news for the UK economy.

Surely the availability of cheaper energy and lower living costs should help not only households but businesses?

Demand ought to increase as prices decrease, right?

Until the nineteen-thirties, in the wake of the Great Depression, this was more or less the received wisdom when it came to dealing with a deflationary economy.

Left to its own devices, it was held that the market would right itself: falling costs would encourage consumption, ultimately causing prices to restart their inevitable climb.

As it turns out, however, consumers are less inclined to part with their money on Monday when they believe they may be able to pick up a better deal on Tuesday.

What that means is that once deflation begins, its momentum is often difficult to arrest, with prices, wages and investment continuing to spiral downwards.

One measure at the disposal of central banks for tackling deflation is the lowering of interest rates.

The problem for the Bank of England is that rates already sit at a record low of just 0.5%, which doesn’t leave the governor a great deal of room for manoeuvre.

Not long ago, Mark Carney was publicly mooting the idea of raising interest rates.

Now, it seems far more likely that he will be forced into a further cut, possibly to as low as 0%.

In the short term, the latest inflation figures should not be a cause for disproportionate concern. It is by no means time to withdraw your savings, close your bank account, and stow your kids’ inheritance under the mattress.

As economists are wont to point out, there is a difference between “good” deflation and “bad” deflation.

The former is the type we are experiencing at present; characterised by falling commodity prices and a correlative increase in consumer spending power.

So long as it is carefully monitored by the Bank of England, a short deflationary period of this kind will do little harm to the economy, and may even help to boost consumption.

If, on the other hand, falling prices in one sector are allowed to bleed into others, causing price stagnation across the board, then we might have a real problem on our hands.

This form of “bad” deflation is the sort that has persisted in Japan for years: a trend impervious to the central bank’s move to slash interest rates.

The UK government will no doubt spin February’s inflation figures as proof of economic prudence, a successful taming of the rampant inflation that characterised the 1980s.

While that may seem like cause for celebration, the fact that the inflation rate is currently well bellow the target of 2% poses a new set of challenges to those at the Bank of England.

The scale of these challenges will likely become apparent in the coming months.