How worried should businesses be that UK inflation has fallen to zero?
For the past three decades, defeating inflation and achieving price stability have driven UK economic policy. Now, for the first time since records began in 1960, UK inflation has fallen to zero, down from 0.3% in January. It will, in all likelihood, fall again this month, resulting in deflation. From 2008 to 2012, inflation was allowed to run significantly above the Bank of England’s (BOE) 2% inflation target, without an aggressive interest rate response. The current flat rate comes as falling oil prices put the skids on prices.
Business groups overall seem to be welcoming the news but uncertainty about future inflation could cause companies to delay investment. Low inflation makes the repayment of outstanding debt more difficult and could even be the result of something more sinister. There are signs, however, that the current situation won’t last.
This fall in inflation hands the chancellor George Osborne a pre-election boost as people go to the polls with more money to spend. He took to Twitter to write: “Inflation at zero is a first for the British economy. Low inflation due to falling oil prices is good news for family budgets.” British holidaymakers heading abroad this summer may not be so pleased as sterling was down 0.4% against the euro, but just how worried should British SMEs be by the news?
“Depressed wages could hamper productivity,” Cyrus Afkhami, founder, My Tutor Club
It seems increasingly likely that inflation will remain significantly lower than 2% for the foreseeable future. With the recent announcement earlier this week that the official inflation figure is a paltry 0%, there are some implications of falling prices for business.
The short-term consequence is that people feel richer; in short, their spending power increases and every pound goes further. On the face of it, this bodes well for businesses as consumers, buoyed with this extra confidence, make purchases that otherwise they may not have made previously. However, if inflation remains at 0% or turn to deflation, the medium-to-long-term impact on businesses, and indeed the wider economy, would become damaging – we would experience stagflation. The risk with deflation is that if consumers expect prices to continue falling then over time they are more likely to defer purchases in an effort to secure even lower prices in the future. This deferment can depress economic activity and have negative knock-on effects throughout the rest of the economy, just as Japan has experienced since the 1990s.
The spectre of deflation may also provide an opportunity for business to freeze wages; this may reduce costs in the short term but depressed wage growth can reduce incentives amongst employees and hamper productivity. It does seem that we are some way off the negative effects of deflation – Eurozone countries are slightly more concerned – but nevertheless even the mere possibility of falling prices can dampen investor sentiment and confidence.
“Counter measures will be good for business,” Ivan McKeever, CEO, SwitchMyBusiness.com
The prospect of negative inflation or deflation might appear to be a concern for business but in reality the causes are more anomalous. If the economy does dip into deflation it won’t last for long as the prospect of long-term deflation – where purchasers defer their purchase for fear that it will effectively become cheaper – has a damaging downward cyclical effect on the economy.
The likelihood is that if deflation looks more than fleeting the Bank of England will start further quantitative easing and could possibly reduce interest rates to zero or even negatively from the current base rate of 0.5%. These measures would speed up the economy. However, this could create too much heat meaning increased interest rates, which will inevitably happen at some stage in the future, thus putting strain on company and house hold debt.
Measures which are taken to stave of the risks of deflation could actually be a good thing for business but the counter measures used to control potential rising inflation could be the hangover of a pleasant upturn for business.
Low inflation should have a positive effect on wages. Assuming the average pay increase is 2% and the inflation is currently zero, this would equate in real terms to a pay increase of 2% above inflation. This should counter the erosion of living standards caused by wage growth stagnation and high inflation experienced in the economy from 2008 – 2013.