The central economic question facing Britain’s top boffins at the Bank of England is deflation and what it means.
Inflation and deflation are just fancy terms to describe price rises and price drops. The way the UK measures inflation levels for the entire country is through the consumer prices index.
The CPi, as it is more often known, simply takes a basket of popular goods and services that most families buy and monitors the average cost of them.
The price of oil could fall while the price of food rise but you take it altogether as an average and come up with a figure. If the average prices rise by 2% then we have 2% CPI inflation.
Now, inflation matters because if, say, wages are increasing by an average of 1 per cent across the country then it means they are falling in real terms.
That would mean that what you are buying is becoming more expensive whereas what you are receiving is worth less.
In order to give the country a steady level which they can plan around the Bank of England has been set an inflation target of 2% a year.
The ideas is that this will create a stable economic environment that can allow people and businesses to make financial plans.
The only problem; the Bank has been missing this target for years. Normally this is down to global events out of its control.
For example, when food prices rose sharply after 2010 inflation hit a high of 5.2%, meaning families are spending more of their disposable income simply to maintain the same living standards.
When you consider average wage rises were around 1 per cent it is little wonder the gap between wage increases and inflation became a political issues. Labour leader Ed Miliband has famously branded it a cost of living crisis.
The normal reaction to high inflation is to raise interest rates. This increases borrowing costs, cuts back on consumer spending and brings prices back down.
But in today’s globalised world controlling national prices through interest rate movements is becoming increasingly more difficult.
Deflation
This brings us to today’s problem; the risk of deflation. While high inflation eats into incomes of ordinary people, deflation can be an even bigger peril.
If prices are falling across the country then people stop spending on non-essentials. For instance, would you buy a television today for £100 if you knew it would worth £98 in one week’s time.
The problem is more pronounced for businesses who stop investing as they fear their purchase will fall in value. It is a dangerous spiral.
Today, UK CPI inflation is at 0.3% a year – way below its 2% target – and largely down to falling oil and food prices.
The Bank of England is warning there could be deflation, locking Britain into the spiral described of holding back spending and waiting for further price falls.
The normal response to deflation risks is to decrease interest rates to encourage borrowing and spending and bring prices back up.
But with two big drags on prices – falling oil and food costs – policymakers are reluctant to loosen the cost of borrowing further.
If policymakers are right and this level of very low inflation or deflation is related to specific factors then it could be a boon to consumers.
Bank of England governor Mark Carney says he is considering a further rate cut beyond the rock bottom 0.5 per cent level currently enjoyed by mortgage borrowers.
It raises the spectre that inflation – or deflation – levels could see further drops in mortgages rates tied to standard variable rate deals or trackers.
Let’s hope the Bank is getting it right and falling prices mean more money in your pocket from the goods you buy and the mortgage costs on your home.
