Falling prices

Too much of a good thing?

It’s not only the winter sales that help explain why many purses and wallets are being opened with an extra smile these days. Annual headline inflation, defined as the percentage change in the price of a basket of goods and services bought by a typical household during the last year, is well below the government’s 2 per cent target and expected to fall even lower in the next few months.

But these softer price pressures, which largely reflect falling import and raw material costs as well as supermarket ‘price wars’, are causing officials at the Bank of England some concern.

Admittedly, being perennially worried about real or imaginary foes is part of the training at Threadneedle St, but there is a deeper issue. In a nutshell, there the Bank is afraid that current events could actually morph into a bout of outright deflation, which is when the basket is cheaper now that at this time last year.

On the face of it, an environment of everlasting price drops sounds heavenly. But there are some damaging side-effects.

For a start, persistently falling prices would see us more inclined to delay today’s non-essential purchases in anticipation of even lower prices tomorrow, and so on. Such ongoing postponements would quickly morph into an economic tailspin as household spending and business investment dried up. Moreover, if the prices at which their products are being sold for are falling, firms are likely to respond to the hit to their profits by bearing down on costs which will undoubtedly see downward pressure on wages and jobs. Finally, anyone who has any form of debt such as a mortgage, loan or credit card, would be frowning because inflation actually reduces the burden of debt, and the higher the better. Suppose you owe £1000 to be repaid in a year’s time. If annual inflation is running at 50% at that point, then that £1000 will only be worth £500 in terms of the basket of goods that it can buy. To even things up you should really be paying back £2000.  Of course, the process also works in reverse. Falling prices mean that you end paying back more than you borrowed in terms of what it can buy. Clearly, no economy can prosper under a long and aggressive bout of deflationary pressure.

The good news is that the current spell of price weakness, just like the seasonal sales, is set to end soon. Indeed, the downward pressure from oil and import prices is already beginning to bottom out. It won’t be long before the Bank of England redirects its fretting elsewhere.

 

Twitter: @marshanalytics

 

 

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