The UK has now
experienced deflation for the first time since records began in 1996. The
Office for National Statistics believes that the last time the UK experienced
deflation was in the 1960s.
This was so long ago
that you may well be asking yourself “What exactly is deflation and what does
deflation mean for our economy?”.
Inflation
v Deflation - What's The Difference?
In very simple terms,
inflation is when the overall cost of living goes up and deflation is when the
cost of living goes down. The word overall is important because prices of
different items can go up and down at different times.
How Is The
Overall Cost Of Living Measured?
There are two main
measures used for determining changes in the cost of living. The older
method is called the Retail Price Index (RPI). This was introduced in
June 1947. The newer method is called the Consumer Price Index (CPI) and
was introduced in 1996.
Both systems use an
“average basket of goods” to keep track of how much “average consumers” are
spending. In other words, they select a range of items which they think
most people need (or want) to buy. They then track the prices of these
items.
There are, however,
important differences in what they track. For example, the RPI includes
the cost of housing (including the impact of Council Tax) but the CPI does not.
They also use different methods for calculating the average.
Summing all this up in a
nutshell, the CPI is almost always lower than the RPI.
Can Inflation
Be Managed?
It is the Bank of
England's job to try. The BoE runs the Monetary Policy Committee.
This has the job of achieving exactly 2% inflation per annum.
Of course, that's a
difficult job so the Bank gets a bit of breathing space. The government
accepts inflation of between 1% and 3% per year.
If, however, inflation
goes either higher or lower, the BoE is called upon to explain itself.
The Governor of the Bank of England, must provide a public, written explanation
of why it missed its target.
It must also advise the
government what it intends to do to get back on target. The BoE's main
tool for managing inflation is the use of interest rates. In very basic
terms, raising interest rates encourages people to save. Lowering
interest rates encourages people to spend.
Why Does
The Bank Of England Try To Keep The Cost Of Living Going Up?
In very simple terms,
deflation has much the same effect as waiting for the January sales to buy
Christmas presents.
Customers assume
(rightly or wrongly) that the item(s) they want will be cheaper after Christmas
so they wait until then to buy them.
Extended periods of
deflation can essentially become a time of Mexican standoff. Buyers get
used to seeing prices dropping so they put off making purchases to get lower
prices.
Unfortunately this can
put producers (and retailers) out of business. Over the long term, this
reduces supply and can stimulate inflation. In the short term, however,
it can lead to painful redundancies.
At the moment, for
example, low oil prices are leading to layoffs in the oil industry.
So Is
Deflation Always Bad?
That is an interesting
question. It is possible that some deflation on essential items such as
food and utilities might actually be helpful. It would give hard-pressed
families a respite.
It might even be enough
to free up money for other purposes. For example, it might allow families
to pay down debts. It might allow them to treat themselves to some
non-essential purchases.
The question would be
whether or not the end producers would be able to support deflation for any
meaningful length of time. If not, then the pendulum could swing the
other way towards high inflation – and cause a lot of pain in the process.
For more information please do not hesitate to
contact the team at Ward Williams Financial Services Ltd on 01932 830664 or
by email on wwfs@wardwilliams.co.uk.
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