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Why You Should Be Worried About Deflation

This week saw the lowest level of inflation since the consumer prices index (CPI) was introduced in 1988, with it reaching just 0.3% in January. Clearly, this could be viewed as good news since it means that the cost of living ‘crisis’ is petering out and that household budgets are going much further than they were even a few months ago.

Deflation Risk

However, low inflation can quickly become deflation and, in fact, the Bank of England now believes that a short period of deflation will take place during the next few months. This, though, is being viewed as a good thing by many consumers and economists and has even been referred to as ‘good’ deflation due to its positive impact on the purchasing power of wages.

Deflation, though, carries with it a major risk that is incredibly difficult to get rid of. In fact, Japan has been trying (and failing) to rid itself of deflation for around twenty years, with numerous fiscal stimulus packages failing in the long run to cause the price level to increase. The effect of this has been a so-called ‘lost decade’, where economic growth has faltered and Japan has, in relative terms, become poorer.

Spending Delays

The reason why deflation can be a severe problem is that it encourages individuals and businesses to delay purchases. This is a completely logical response to falling prices: if you can buy something cheaper in a week, month or a year’s time, then why would you buy it now? The effect of this is to reduce consumption and this can push any economy into a recession. Subsequently, with confidence being low, it is very difficult to bring inflation back and it becomes something of a ‘snowball’ effect.

Looking Ahead

Clearly, the UK is not yet experiencing deflation and, if it does, it could be argued that the Bank of England has the necessary tools to fight it in terms of reducing interest rates and using further quantitative easing. However, as Japan has showed, they may not be enough and the impact of deflation on any economy can be devastating.

So, while deflation may at first seem like a good thing, its impact on the wider economy can end up having a direct influence on your and your finances. As such, it may not prove to be the positive phenomenon that many commentators would have you believe.

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