How will you be affected by negative inflation?


November 2015

How will you be affected by negative inflation?

As we recently reported, October 's inflation figure as measured by the CPI index is currently set at -0.1%, making this the second consecutive month of negative inflation. But what exactly does this mean? And how will it affect you?

What does negative inflation actually mean?

We are currently in a period of negative inflation according to the Consumer Price Index measure. The CPI tracks changes in the cost of what is known as a market basket of goods ñ a cross section of basic goods such as clothing, food, tobacco and energy supplies.

This month 's figure was influenced strongly by a drop in prices for fuel (which fell by 14% in the year to October), food and drink (which fell by 2.7%) and energy (which fell by 4.1%). Tobacco and alcohol prices also fell, with only an increase in clothing prices offsetting the drop.

It 's worth noting that CPI is not the only measure of inflation; there is also the Retail Price Index, according to which inflation this month stood at 0.7% (down from 0.8% in the previous month), and core inflation as measure by the ONS, which is currently just over 1%.

Negative inflation is traditionally used to describe times when, for a short-term or temporary period, inflation is below zero. If this term continues to the point where the below-zero-inflation becomes a trend, then this becomes all-out deflation.

How long will it last?

One big question then that economists are trying to answer, in order to assess the severity of our current negative inflation, is how long it is likely to last. And there isn 't a huge amount of consensus on this point.

Paul Hollingsworth, an economist at Capital Economics, is fairly optimistic, arguing that "we doubt that we are entering a new era of zeroflation or noflation. Indeed, inflation looks set to pick up around the turn of the year as we reach the anniversary of previous sharp falls in oil prices."

In the other camp, more pessimistic about how long this period will last, is Kingston University 's Prof. Steve Keen, who believes that unless government policy of austerity changes, then we may be in it for the long haul.

"On our current policy settings," he said, "I 'd say it 's guaranteed, but it won 't be a runaway process."

He believes that inflation is likely to "taper to a level in the zero to -2% range," comparing our experience to what Japan, who have a long history of deflation, peppered with relatively sharp by short-lived periods of inflation brought about by reactionary but ultimately ineffective fiscal stimuli

"Some mild inflation," he said of Japan "has resulted whenever the government has run a fiscal stimulus, only to peter out back into deflation when the stimulus was removed."

So, is it good news or bad news?

Both of the aforementioned economists, and indeed most analysts with any sense, agree that long term deflation is not good, for a variety of reasons.

On the one hand, it can stall markets like the housing market, as potential buyers become more reluctant to spend right away in case prices continue to fall. And further, it can delay investments as firms "become less certain about future profits" says Hollingsworth. This uncertainty can even translate into shrinking wage growth.

And further, long term deflation can "also cause asset prices more generally to fall", generally weakening markets all over.

Interestingly though, Hollingsworth argues that this current short-term negative inflation we 're experiencing isn 't really such a bad thing at all; pointing out that with prices slowly decreasing for the time being, "households ' purchasing power" will be increased, while "firms ' day-day costs" will go down. The former is particularly relevant given that much of the fall in prices applies to very basically useful commodities like petrol, food and drink, and energy.

Keen disagrees. "Deflation is only benign ñ or even beneficial ñ in a world in which no one has any debt" he said. "With debt," he went on, "deflation amplifies your indebtedness, which is what happened during the Great Depression."

He went on to more explicitly describe the negative effects deflation has on savers, saying that "1% deflation on a 3% mortgage rate means you have to give 4% of your real income to the bank."

Essentially, the answer to the question of how good or bad a thing this negative inflation is depends on both the perspective of he who answers, and to whom the answer applies.

While long term deflation is generally considered to be a bad thing, there are some who would benefit. And of course, the same goes for short term negative inflation.

Those on fixed incomes, for example, are likely to benefit since their spending power will be increased as the price of goods goes down.

"It is also good for creditors" said Prime Economics ' director Ann Pettifor, "because while prices increased can fall below zero, effectively turning negative, interest rates for loans and mortgages cannot.

"So while wages or incomes may fall, interest rates (once they hit the 0% level) will effectively rise relative to these falls."

Savers could also benefit, says Patrick Connolly as Chase de Vere, since while they "may feel disadvantaged in absolute terms" due to low returns that result from the low interest rates that tend to follow negative inflation; "in a deflationary environment, savers are at least making money in real terms."

Wider implications

As we just alluded to, negative inflation tends to have a knock on effect that keeps interest rates low. Indeed this is exactly what we 've seen here in the UK where interest rates have been held at their record low of 0.5% for at least seven years now.

This, in essence, spells good news for borrowers, but bad news for savers. Though again as we just mentioned, the hit savers will take might not be quite as bad as it at first seems.

Those looking to borrow in a (even mildly) deflationary environment should be on the lookout for fixed rate deals, which will be at their lowest right now. Kay Ingram, one of LEBC 's financial advisers, echoed this.

She also issued a warning to those looking to purchase properties with mortgages for the purposes of investment however. "A deflationary market will increase the illiquid nature of property investments, the time taken to sell and realise capital is likely to increase, so only those who can afford to wait to realise their investment can afford this risk."