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What Is Negative Inflation?

by The Bankruptcy Service

Posted on October 28, 2015 at 11:45 AM

Petrol Pump

At the Bankruptcy Service, we have a look at negative inflation, and its effect on economies.

We all know what inflation is – a figure that tells us if the price of a huge range of goods and services is going up or down. For the UK, the general trend has been that of goods gradually going up in price. The inflation figure is worked out by the Office of National Statistics (ONS) who use the Consumer Price Index (CPI) to make their calculations.

The ONS look at the price of a vast range of items that we all (between us) buy and estimate the current prices for such items. There are hundreds of thousands of items on this list, and together they can gauge if prices have gone up or down. The exhaustive list of items thus contains pretty much everything you could buy – alcohol, food, clothing, repairs, DIY, housing utensils, jewellery, watches, hairdressing, restaurants, education, holidays, books, newspapers, photographic equipment, dental spend, medicine, cars, bikes, cable subscriptions, telephone services and much, much more.

Inflation has traditionally always been above zero, as most things in life have become more expensive year-by-year. That was, until April 2015, when for the first time since 1960 we saw a month of negative inflation, at -0.1%. The figure you see is calculated by assessing priced compared to the same month a year before. In other words, a basket of goods that would have cost £100 in April 2014 was calculated to cost £99.90 in April 2015. The biggest contribution to the fall came from a drop in air and sea fares, and at the time the figure was released, the Bank of England governor Mark Carney said he expected inflation to remain very low for a few months. The -0.1% figure is negligible in the difference it makes to our daily lives however.

It sounds like great news, which it is essentially, but it doesn’t come without risks. Firstly, inflation rates are often closely linked to interest rates, as the Bank of England, who set the interest rate, use the inflation rate as a guide. Thus, if inflation rates drop, so may interest rates, which naturally has a negative effect on savers. However, the opposite is the case for borrowers, who may be able to gain more competitive rates than previously.

What’s more, with wages increasing by 1.9% on average currently, a fall in prices, or even a static market, means more money in the pockets of many of us, especially as food and petrol prices have had a period of price decreases. A short burst of negative inflation is thought to stimulate an economy, though others warn that it can be a sign of a fragile economy. Whilst wage increases may be performing above the rate of inflation, it would be hard for union leaders to push for any additional wage rises for their members whilst inflation remains at such a low level.

The biggest beneficiaries are those who have fixed increases on money they receive – such as pensioners who are locked into 2.5% increases in state pensions. Also, those on the minimum wage, which is thought to number 1.4 million, should see a scheduled rise of 3%, though this only equates to 20p an hour, and won’t come into force until October.

The inflation figures for April showed that transport costs were 2.8% lower than the same time a year ago, while food was 3.0% cheaper. The Chancellor George Osborne said the inflation figure should not be mistaken for "damaging deflation".

A small period of “deflation” is fine, but if there is an anticipation of sustained negative inflation, then there are other downsides to such a trend. Consumers tend to spend less as they decide to wait for even bigger bargains in the future as prices plummet, businesses may invest less, and wage rises may stall, as they are linked to inflation, so that workers don’t lose out in “real terms”.

And economic experts would not class a small period of negative inflation as “deflation” as such. Economists tend to define a brief dip below zero as the aforementioned “negative inflation”, to distinguish what is likely to be a temporary spell of falling prices on the back of one-off factors from outright deflation. Having said that, the ONS did report the April figures as deflation, so the definition is open to debate.

Economists also look at core inflation, which strips out the more volatile prices such as energy and food to judge whether we should fear a sustained period of deflation. Core inflation in April was 0.8%, the lowest since March 2001, but still well above zero, and unlikely to go any lower than that in the foreseeable future.

The dip in inflation is a trend that has been mirrored elsewhere. Eurozone inflation was negative between December 2014 and April 2015, and the US rate turned negative in January before recovering to zero in February.

As mentioned already it wasn’t expected to last, but it has. The following month saw a figure of 0.1% inflation, and experts expected that to rise steadily now back to more “normal” levels – perhaps up to the government’s target of 2% inflation. However, the rate has stayed flat for six months now, and in September 2015, returned to 0%. It will be interesting to see if it does rise again in due course.

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