MarketLine Blog

Keep calm and take advantage. Deflation, good for the consumer, not so good for business

On Tuesday, May 19, 2015, it was announced by the Office for National Statistics (ONS) that the UK had fallen into deflation for the first time since 1960. The Consumer Price Index (CPI) fell by 0.1% in the year to April 2015, compared to no change (0.0%) in the year to March 2015.

According to the ONS, this is the first time the CPI has recorded a decline over a year since official records began in 1996, and is the first instance of deflation when using comparative data since 1960. But what does it actually mean?

Moderate inflation is generally regarded as good for economic growth, with most of the world’s central banks targeting an annualized inflation rate of 2 to 3%. However, when inflation gets out of hand, prices rise too quickly for incomes to adjust, which can potentially lead to hyperinflation where price rises get out of control, rendering the concept and benefit of inflation meaningless. This can lead to a number of economic issues such as a loss of confidence in a currency’s ability to maintain its value, and with rapidly rising prices consumers find they can no longer afford even basic goods and services.

The opposite, deflation, occurs when the change in prices turn negative, usually during and after periods of economic crisis.  During the Great Depression of the 1930s, economies around the world experienced crippling deflation as production ground to a halt and general annualized price levels declined 10%.

After the Great Recession of 2008, the US barely avoided a deflationary spiral, and today, economies of the Eurozone are struggling to combat deflation, with the European Central Bank (ECB) undertaking quantitative easing as a preventative measure.

When deflation typically occurs during or after a severe recession, economic output slows as demand for consumption and investment drops. As is to be expected, supply and demand economics demands that prices fall, with producers forced to liquidate inventories that people no longer want to buy. This starts a vicious cycle as consumers and investors alike hold on to liquid money reserves to protect themselves against further financial loss. As more money is saved, less is spent which further decreases aggregate demand, placing more downward pressure on prices.

However, the UK deflation announced by the ONS has occurred during a period of economic recovery and growth for the country, and is the result of very different factors.

Falling global oil prices have exerted downward pressure on fuel and energy prices in recent months, although petrol prices in the UK have seen a rise which reflects the slow rebound in oil prices seen more recently. However, this has been offset by a 5% cut in gas prices by British Gas, the UK’s largest energy supplier.

Further price pressure has been exerted by the country’s supermarket price wars, a result of falling market share and revenues from incumbents Tesco, Sainsbury’s and Morrisons due to fierce competition from discount chains Aldi and Lidl (Aldi recently became the UK’s sixth largest grocer, overtaking former incumbent Waitrose). The major supermarkets have been forced to slash prices on many items, with no end to the price wars immediately apparent.

As a result, food price deflation has hit close to 4% year-on-year, a major relief to consumers in the wake of rapid price rises during 2007-2013 (food price inflation stood at an annual average of 5% during this period).

Although deflation is bad for business, the consumer will benefit the most. Moving to assuage fears, the UK Chancellor, George Osborne, states the UK is not facing damaging deflation. The combination of rising wages, falling unemployment and falling prices is good for the consumer.

With increased employment, economic growth, and wage rises outstripping deflation and resulting in increased disposable income, consumers will have the confidence to take advantage of low prices.

Furthermore, with confidence in the form of continuity as a result of the newly elected majority government, Mark Carney’s (the Bank of England’s Governor) advice to ‘enjoy it while it lasts’ can be seen as sound consumer advice as the UK’s CPI is likely to return to growth later this year.

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