One grim spectre of the interwar period has thankfully not arrived in the UK: deflation. Although it was revealed on Tuesday that the retail prices index dropped over the past year, the country is not experiencing widespread deflation. Nor does it seem imminent.
A long period of falling prices in the UK would be enormously destructive. Fixed-price debts would stay the same size while incomes and earnings would shrink. In the most famous episode of debt-deflation, Irving Fisher estimated that the real burden of borrowing increased in the US by 40 per cent between 1929 and 1933. A deleveraging UK economy, whose debts grew as consumers and companies tried to cut their costs would beach itself.
For such deflation to emerge, as in Japan’s “lost decade”, not only must prices fall, but a widespread expectation that prices will keep on falling must also become embedded among consumers and businesses. This is not an idle danger: Bank of England surveys reveal that the British public’s expectations for future inflation are dropping rapidly. Meanwhile, the yield spread between inflation-linked and conventional bonds implies that market expectations for future levels of RPI growth is extremely low.
But the UK is still far from deflation. Tuesday’s announcement of a drop in the retail price index of 0.4 per cent over the past year occurred only because mortgage interest payments have fallen. The Bank of England’s rate-cutting has generated this apparent deflation; but for the big falls in housing costs, the RPI would in fact have risen by 2.2 per cent. The consumer price index, which excludes mortgage costs, is up by 2.9 per cent on the year before – 0.9 percentage points above the Bank of England’s inflation target. Only a small minority of households is experiencing real falls in the cost of living.
Deflationary fears will also be eased by sterling’s slide; it has lost a quarter of its value against other currencies on a trade-weighted basis since its 2007 peak. Even if the pound now stabilises, the increased cost of imports will continue to feed into the UK for some time, creating upward pressure on a range of import-linked prices.
Finally, just as inflation is a monetary phenomenon, so too is deflation. The Bank of England has started quantitative easing; it is now increasing the money supply at rates that it judges to be consistent with 5 per cent nominal output growth. This is appropriately aggressive monetary policy. Deflation is a serious risk. But, despite this week’s negative news, it is not an immediate threat.
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