Why 1% Inflation Could Be Good News For The FTSE 100!

Today’s news that inflation fell to 1% last month has been widely welcomed. After all, it means that the cost of living for people across the UK is going up at its lowest rate in around twelve years, with the plunging price of oil and supermarket price wars being the major contributors.

Hopefully, as the Bank of England predicts will happen, wage rises will now remain ahead of inflation during 2015, which will help to alleviate the cost of living squeeze that has largely been present since the start of the credit crunch. Such a situation could boost the earnings of a number of consumer goods companies over the medium term.

Of course, the effect of such a low level of inflation on the FTSE 100 could also be significant. That’s because a falling rate of inflation could cause the Bank of England to become rather uneasy regarding the medium term prospects for price levels, with the possibility of deflation being perhaps being the greatest fear of any central banker. This is the case because once deflation takes hold, it can be hugely challenging to overcome and can wreak havoc on an economy.

For example, with prices falling, consumers put off purchases for as long as they can. This can cause a prolonged recession to take place, with confidence among consumers and investors alike being low and, as a result, it can be a major challenge and a vastly costly experience to overcome deflation. A good example of this is Japan, which despite having thrown £billions at its deflationary woes has failed to deliver strong, stable and consistent economic growth over the last couple of decades.

So, just as is taking place in the Eurozone at the present time, central banks are likely to do whatever it takes to avert the threat of deflation. And, while the UK’s inflation rate is higher than that of the Eurozone (1% versus around 0.3%), it seems more likely now that an ultra-loose monetary policy will remain in place until this threat is averted. Furthermore, additional QE cannot yet be ruled out should the growth rate of the price level in the UK continue to fall.

Of course, a low interest rate and more QE would be great news for the FTSE 100. They would encourage investment rather than saving and a consequence of further QE is likely to be improved sentiment among investors and higher asset prices. In fact, it is arguable that the bull run from March 2009 until this year was at least partly the result of QE, so more of it could provide short term strength to the wider stock market moving forward.

As a result, and while the effect of low inflation on consumers may grab the headlines, the impact on the FTSE 100 could prove to be much greater (and more positive) for investors in 2015.

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.