Why some economists think the UK could face ‘deflation’

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The UK could see inflation fall below its target level of two per cent this year – or even experience ‘deflation’ – two economists have claimed.

Julian Jessop, an independent economist who is a fellow at the Institute of Economic Affairs think-tank, thinks there’s a significant possibility that inflation will go sub-zero, something that seemed incredibly unlikely a year ago when it sat in double digits.

He told i there is now a “good chance” of deflation happening, or at least, a prolonged period of the Consumer Prices Index (CPI) remaining below target.

Deflation is when prices decrease over time and purchasing power increases. It means you can buy more goods or services tomorrow with the same amount of money you have today. However, while it may seem like good news, it could signal hard economic times.

This is because when consumers feel prices are reducing, they could delay making purchases in the hopes they can buy things for less at a later date. Reduced spending can lead to less income for producers, which can result in unemployment and higher interest rates.

The prediction of deflation is a little different to those made by some forecasters, even though many have revised down their forecasts in recent weeks.

Deutsche Bank suggested inflation will be 2.5 per cent this year, on average, perhaps dipping below the target level slightly in April and May, and then hovering at 2 to 2.5 per cent for the rest of the year.

But Mr Jessop thinks there are two possible scenarios. “One possibility is that we have large falls in energy and food prices as recent supply shocks unwind,” he says.

“This could result in an outright fall in the overall inflation figure. But as long as core inflation [which strips out volatile measures such as food and energy price changes] is still positive, this would be nice problem to have,” he explains.

Another scenario he believes could happen involves price falls being more widespread, which would be more serious.

His prediction is based on some forecasters looking at “individual components” of inflation, which are not his primary focus.

“The most important thing is what is happening to money and credit growth [deposits from and lending to households], which is very weak. There is a lingering risk of recession,” he says.

In a recession, people’s capacity to spend falls, and a vicious cycle can follow, meaning jobs are cut and spending capacity decreases further, so prices growth stalls because people cannot afford to pay more for goods.

Mr Jessop is not alone in thinking that a risk of deflation exists.

Muhammad Ali Nasir, an associate professor of economics at the University of Leeds, says he also thinks it is a “real possibility”.

“I always held the view that [high] inflation is temporary and it would come down,” he says.

He told i that he always expected the revival of economic activity after Covid to push inflation up, but that this would naturally adjust itself.

“Now that inflation has come down sharply, there are downside risks to price stability or, put simply, inflation may undershoot the target,” he adds.

“It is hard to say if we could see deflation but if we do the trend analysis and look at the trajectory, that is where it is heading,” he concludes.

What do the pair think the impact will be if their suggestions come to fruition?

“Falling prices can have all sorts of adverse economic effects,” says Mr Jessop. “For example, consumers may hold back on purchases if they expect prices to keep falling, thus reducing spending.”

“There could be problems for the labour market too. If prices fall but wages don’t, unemployment is likely to increase. If wages also fall, the real burden of debts increases,” he adds.

Dr Nasir agrees that deflation would have “severe consequences” and says the economy could well stagnate.

The pair both think the Bank of England should in all likelihood cut interest rates in order to lower the risk of that happening.

Dr Nasir thinks there is a strong case for the Bank to cut rates from February if inflation continues on its downwards trajectory when December’s figures are published on Wednesday.

Mr Jessop adds that he believes the Bank should be cutting interest rates anyway because inflation is on track to hit its 2 per cent target earlier than anticipated.

“The case for doing so will be even stronger if inflation is likely to undershoot the target for a prolonged period,” he says.

However, three of the Bank’s Monetary Policy Committee members preferred to raise the rate by 0.25 points, to 5.5 per cent, in the last interest rate decision, suggesting cuts may not be in the immediate future.

Other economists, including those at Deutsche Bank, also believe there will be more inflation drops but they will slow.

Broadly, the Bank ups interest rates when inflation is high, with the logic being that if the cost of borrowing is more expensive and saving more rewarding, people spend less, and therefore demand is cut, and prices increase slowly.

But a risk is if people do not spend enough, the economy stops growing. The economy has been yo-yoing in recent months, growing by 0.3 per cent in November after a fall in October, but is broadly flat.

For now, it remains to be seen where inflation is heading, although Wednesday’s figure will give a better indication of things to come. November’s figure stood at 3.9 per cent, and forecasters are predicting a marginal fall, possibly to 3.8 per cent.

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