Inflation rises, but we should still fear deflation

Powered by article titled “Inflation rises, but we should still fear deflation” was written by Larry Elliott Economics editor, for on Tuesday 16th February 2016 11.44 UTC

The level of inflation poses a risk to the UK economy, but not in the way that you might think. Inflation is worryingly low, rather than worryingly high.

That may seem a perverse idea at a time when the cost of living as measured by the consumer prices index has risen to its highest level in a year. But consider the following.

The annual inflation rate did not rise in January because retailers were jacking up their prices. On the contrary, a representative sample of goods and services measured each month by the Office for National Statistics was 0.8% cheaper in January than it was in December.

Inflation rose because the January 2016 fall in prices was not quite as big as the January 2015 fall in prices. But the first few weeks of 2015 was when motorists really felt the benefit of the first plunge in oil prices.

There has been another downward lurch in oil prices early this year, but its impact has not been as great. Motor fuels and lubricants – the category in the CPI that covers the cost of petrol and diesel – fell by 6.8% in January 2015, but by 2.6% in January 2016.

As a result, the annual inflation rate was always likely to rise in early 2016. The surprise is that it has not risen more.

Indeed, core inflation, the measure of the cost of living that strips out food, fuel and the impact of the chancellor’s decisions on excise duties in the budget, fell from 1.4% in December to 1.2% in January.

None of this is a problem at the moment. Inflation at 0.3% coupled with earnings growth of 2% means that real incomes are growing at a reasonably healthy rate. That should help underpin the economy over the coming months.

Moreover, since the Bank of England is more concerned about core inflation than it is about headline inflation, there is no immediate prospect of interest rates going up. That too should help to keep activity buoyant.

But low inflation could become a big problem if it morphs into deflation, which means a prolonged period of falling prices rather than the sporadic dips into negative territory seen in 2015.

How would that happen? Initially, inflation continues to undershoot official forecasts because employers think they can get away with lower pay offers. There are already signs of this happening. The Chartered Institute of Personnel and Development said median basic pay rises of 1.2% are expected in the year to December 2016, down from 2% three months ago.

That would leave the economy one moderately serious recession away from outright deflation, because a period of weak growth and rising unemployment would bear down on pay settlements and prices in the shops. Does that recession look imminent? No, it doesn’t. Is one possible within the next 12-18 months? One look at the financial markets provides the answer. © Guardian News & Media Limited 2010

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