What is Deflation?
A deflationary climate has returned to Britain for the first time in nearly 50 years.
The Retail Prices Index (RPI) measures a theoretical basket of goods and compares changes in the price of the whole basket over time. For the first time in five decades RPI was lower over a 12 month period.
In March 2009 RPI was 0.4% lower than 12 months earlier in March 2008. In the short-term delfationary pressures could make the recession we are currently going through worse than expected as the general level of prices continues to fall.
Some people argue that falling prices is generally good for consumers, and therefore the economy, however if these deflationary pressures become entrenched over the medium term then this will actually hurt the economy as consumers will effectively stop buying products today in the hope of even greater savings to be made tomorrow.
The Office of National Statistics has said that the largest constituent part of the “basket” which has pushed prices lower was gas and heating oil bills, with falling vegetable prices over the last 12 months also making a contribution.
Aren’t Falling Prices a Good Thing?
Not necessarily as it affects some consumer groups more than others. For example, pensioners receive a State Pension which is linked to RPI – they are therefore seeing little increase in the value of their State pensions. To compound the problem, the basket of goods which the average pensioner purchases is rising in price above inflation – in real terms therefore pensioners are becoming worse off.
Pensioners who depend on their savings for additional income over and above their pension income are also suffering at present from low interest rates on their savings accounts.
Pensioners are likely to see their pensions increase by no more than £2.40 per week next year. State pension increases are set with reference to RPI figure in September which was 2.5%. The likelihood is that State pension will increase by £2.40 per week to £97.65.
The other losers in a deflationary economy are those burdened with debts – they will suffer with the debt-deflation trap – which would see the “real” value of debts increasing as the general level of prices of all other items falls.
Deflation will also affect workers as they are unlikely to receive wage increases – business owners and managers will argue that the deflation of prices in the economy is providing a boost to “real” wage values without the need to put their hands in their pockets.
RPI and CPI
The Government’s preferred method of measuring prices is through CPI (Consumer Prices Index) which again uses a theoretical basket of goods and considers the change in prices of these goods and the relative weightings of each good sector within the basket. CPI excludes housing and mortgage costs.
At present CPI is running still in the positive at 2.9% per annum.