The CPI index fell by 0.1% in the 12 months to April 2015. This is partly the result of lower air and sea fares, as the upward ‘blip’ in these fares at Easter last year was not present in mid-April this year as Easter fell outside the period when the statistics are collected. What is more significant is that fuel, commodity and retail food prices have fallen over the past 12 months, and the exchange rate has risen, especially against the euro.
But how do we define what’s happened and how significant is it? It might seem highly significant as it’s the first time in 55 years that the CPI has fallen over a 12-month period. In fact, the effect is likely to be temporary, as fuel prices are now rising again and commodity prices generally are beginning to rise too. What is more, the pound seems to have peaked against the euro. Thus although aggregate demand remains relatively dampened, the main causes of falling prices and potential rises in the coming months are largely to be found on the cost side. This then brings us on to the definition of a falling CPI.
A falling CPI over a 12-month period can be defined as negative inflation. This is unambiguous. But is this ‘deflation’? The problem with the term ‘deflation’ is that it is ambiguous. On the one hand it can be defined simply as negative inflation. In that case, by definition, the UK has experienced deflation. But on the other, it is used to describe a situation of persistent falling prices as a result of declining aggregate demand.
If an economy suffers from deflation in this second sense, the problem can be very serious. Persistent falling prices are likely to discourage consumers from spending on durables (such as fridges, TVs, cars and furniture) and firms from buying capital equipment. After all, why buy an item now if, by waiting, you can get it cheaper later on? This mentality of waiting to spend leads to falling aggregate demand and hence falling output. It also leads to even lower prices. In other words deflation can get worse: a deflationary spiral.
If we define deflation in this second, much more serious sense, then the UK is not suffering deflation – merely temporary negative inflation. In fact, with prices now falling (slightly) and wages rising at around 2% per year, there should be an increase in aggregate demand, which will help to drive the recovery.
Should Britain Panic Over Negative Inflation? Sky News, Ed Conway (20/5/15)
UK inflation negative for first time since 1960; BoE says temporary Reuters, Andy Bruce and William Schomberg (19/5/15)
UK inflation negative for the first time since 1960 CNBC, Dhara Ranasinghe (19/5/15)
UK inflation rate turns negative BBC News (19/5/15)
Why there’s little to fear as the spectre of deflation descends on UK The Telegraph, Szu Ping Chan (19/5/15)
UK inflation turns negative The Guardian, Katie Allen (19/5/15)
Is the UK in the early stages of deflation? The Guardian, Larry Elliott (19/5/15)
Is the UK in deflation or negative inflation? Q&A The Guardian, Katie Allen and Patrick Collinson (19/5/15)
Market View: Economists unconcerned on temporary deflation FT Adviser, Peter Walker (19/5/15)
- Is negative inflation ever a ‘bad thing’?
- Explain the movement in UK inflation rates over the past five years.
- How do changes in exchange rates impact on (a) inflation; (b) aggregate demand? Does it depend on what caused the changes in exchange rates in the first place?
- Why is the current period of negative inflation likely to be short-lived?
- Would you describe the negative inflation as negative cost-push inflation?
- What factors could change that might make negative inflation more persistent and raise the spectre of deflation (in its bad sense)?
- If inflation remains persistently below 2%, what can the Bank of England do, given current interest rates, to bring inflation back to the 2% target?
- What is meant by ‘core inflation’ and what has been happening to it in recent months?
- What global factors are likely to have (a) an upward; (b) a downward effect on UK inflation?
Christine Lagarde, managing director of the IMF, has warned of the danger of deflation in the eurozone. She also spoke of the risks of a slowdown in the developing world as the Fed tapers off its quantitative easing programme – a programme that has provided a boost to many emerging economies.
Speaking at the World Economic Forum, in the Swiss Alps, she did acknowledge signs of recovery across the world, but generally her speech focused on the risks to economic growth.
Some of these risks are old, such as a lack of fundamental bank reform and a re-emergence of risky behaviour by banks. Banks have taken steps towards recapitalisation, and the Basel III rules are beginning to provide greater capital buffers. But many economists believe that the reforms do not go far enough and that banks are once again beginning to behave too recklessly.
Some of the risks are new, or old ones resurfacing in a new form. In particular, the eurozone, with inflation of just 0.8%, is dangerously close to falling into a deflationary spiral, with people holding back on spending as they wait for prices to fall.
Another new risk concerns the global impact of the Fed tapering off its quantitative easing programme (see Tapering off? Not yet). This programme has provided a considerable boost, not just to the US economy, but to many emerging economies. Much of the new money flowed into these economies as investors sought better returns. Currencies such as the Indian rupee, the Brazilian real and the Turkish lira are now coming under pressure. The Argentinean peso has already been hit by speculation and fell by 11% on 24/1/14, its biggest one-day fall since 2002. Although a fall in emerging countries’ currencies will help boost demand for their exports, it will drive up prices in these countries and put pressure on central banks to raise interest rates.
Christine Lagarde was one of several speakers at a session titled, Global Economic Outlook 2014. You can see the complete session by following the link below.
Lagarde warns of risks to global economic recovery TVNZ (27/1/14)
Lagarde Cautions Davos on Global Deflation Risk Bloomberg News, Ian Katz (26/1/14)
Davos 2014: Eurozone inflation ‘way below target’ BBC News (25/1/14)
IMF fears global markets threat as US cuts back on cash stimulus The Guardian, Larry Elliott and Jill Treanor (25/1/14)
Davos 2014: looking back on a forum that was meant to look ahead The Guardian, Larry Elliott (26/1/14)
Speeches at the WEF
Global Economic Outlook 2014 World Economic Forum (25/1/14)
- Why is deflation undesirable?
- What are the solutions to deflation? Why is it difficult to combat deflation?
- What are the arguments for the USA tapering off its quantitative easing programme (a) more quickly; (b) less quickly?
- How is tapering off in the USA likely to affect the exchange rates of the US dollar against other currencies? Why will the percentage effect be different from one currency to another?
- What are Japan’s three policy arrows (search previous posts on this site)? Should the eurozone follow these three policies?
’The steepest and longest recession of any developed country since World War II.’ This has been the case for Ireland, which has seen national income fall by 20% since 2007. Many countries across the globe have experienced pretty bad recessions, but what makes Ireland stand out is how it has been dealt with.
In the UK, the government has continued spending in a bid to stimulate the economy and to use Gordon Brown’s phrase from 2008, we have aimed to ‘spend our way out of recession’. Ireland, however, did not have that option. With too much borrowing, Ireland was unable to stimulate the economy and needed to cut its debts in order to maintain its credibility in the eurozone. Last year, significant cuts in government spending were accompanied by tax rises equal to 5% of GDP. Similar action is to be expected in the UK following the election, where popular benefits may have to be reduced, as transfer payments do account for the majority of government spending. Whoever is in government following the election will have some hard decisions to make and everyone will be affected. Read the article below and listen to the interview and think about what the UK can learn from Ireland.
Irish lessons for the UK (including interview) BBC Stephanomics (9/4/10)
- In the interview, Brian Lenihan said that the UK was expecting too much from the falling value of sterling. What was the UK expecting following significant depreciations in the value of sterling and why has that not happened?
- What is a deflationary spiral? Why has it caused Ireland’s public debt to rise so much?
- Why does Brian Lenihan argue that there are limits to how much taxes can be increased? What are diminishing returns to taxation?
- Would the UK be any better off had we joined the euro? What about other countries: would they have benefited had we joined the euro?