Deflation Ahead for UK Economy says Capital Economics

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The UK economy could be about to enter a period of deflation, according to analysis from independent economics research and consultancy firm Capital Economics.

Deflation - where prices fall - is likely to come about as a result of the initiatives announced by UK Chancellor Rishi Sunak last week, where VAT for certain sectors of the economy was slashed in an effort to get coy consumers out and spending once more.

"The reduction in the standard rate of VAT from 20% to 5% between 15th July 2020 and 12th January 2021 for the hospitality/tourism sector and August’s “Eat Out to Help Out” (EOHO) Monday to Wednesday discount scheme, which were announced by the Chancellor last week, will both reduce consumer prices," says UK Economist Paul Dales at Capital Economics.

One question economists have asked however is whether companies within the hospitality sector will pass on the benefits announced by the Treasury or whether they will pocket the gains.

The ONS estimates that about 66% of businesses passed on the 13-month cut in the standard VAT rate for all sectors from 17.5% to 15.0% in December 2008 while the Bank of England estimates the pass-through was about 50%.

However, in a sign that consumers might stand to benefit is news pub chain giant JD Weatherspoon have announced deep cuts to drink and food sales, which other companies looking to boost turnover might follow given the precedence being set.

"One consequence of the new policies announced by the Chancellor last week is that the UK will soon enter a period of deflation. But this will be the good form of deflation, which is temporary, boosts real incomes and incentivises people to spend, rather than the bad form of deflation, which is persistent, reduces wages, increases debt burdens and prompts people to postpone spending," says Dales.

Figures from Capital Economics shows the VAT cut is equivalent to a price reduction of 12.5% (i.e. £100 / 1.20 x 1.05 = £87.50). They estimate it applies to about 9% of the CPI basket (i.e. accommodation, admission to attractions and food/non-alcoholic drink from restaurants, pubs, bars and cafés).

Their research shows that theoretically if all eligible items were reduced in price by 12.5%, the consumer price index would fall by 1.1% and inflation would ease by 1.1 percentage points.

Prices were already heading lower ahead of the government's latest Eat out to Help Out scheme with the UK's Consumer Prices Index (CPI) rising by just 0.5% year-on-year in May 2020, down from 0.8% in April.

This puts the rate well below the Bank of England's mandated target of 2.0% and further declines in inflation suggests further interest rate cuts to 0% or below could occur over coming months.

Capital Economics say on balance CPI inflation could fall to -0.4% in August, meaning this would be the first bout of deflation since October 2015.

"It may seem odd that the Chancellor has implemented policies that will lead to deflation. But this is exactly the mechanism through which such policies stimulate the economy. The reduction in prices increases the real spending power of households (they will be able to buy more goods and services with the same amount of money). And because everyone knows that the price reductions will be temporary, the schemes create an incentive to bring forward spending from the future," says Dales.