The Implications of Low Inflation

As had been predicted, the UK Consumer Price Index (CPI) declined once again -- this time to 1.9 percent, down from 2.03 percent. The likelihood of CPI falling short of the two percent forecasts was something I alluded to in my ‘Week Ahead’ highlights.

With monetary policy predicted to remain loose for longer, Sterling took as a slide against the U.S. Dollar and Euro.

Why does it matter?

For the individual, falling inflation is, of course, a good thing -- provided wages don’t fall in line

Looking at the bigger picture, it means the Bank of England is under even less pressure to raise interest rates. Combine low inflation with the looming 2015 election (don’t believe that Central Bank independence stretches to giving their political overseers an inopportune headache) and I see it as unlikely that we shall see an interest rate rise in the UK before mid-2015.

So, why is CPI inflation falling?

This has coincided with a time of flat-lining oil prices (Brent Crude), which has had the effect of calming pressures on food prices and other activities that incur transport costs, as well as a continuation of the long term trend of falling electrical goods prices, much of which comes from overseas. 

This form of inflation- often referred to as ‘imported inflation’ - has also been getting squashed owing to the fact Sterling has risen over the last year against other currencies.

On the ‘domestic’ side of the equation, wages remain firmly suppressed (having only risen 0.9 percent last year- equating to a decline in real terms) and as such, there is no need for domestic firms to raise prices to cover their cost base.

Looking at the bigger picture, however, it may be indicative of something more sinister: a liquidity trap.

This is exactly what has unfolded in Japan where interest rates have been low for a decade. Put simply, when individuals are unwilling to take on risk -- either due to lack of confidence in the future expected returns, or because of scant enthusiasm for the current rate of return available -- they will simply choose to sit on safe investments.

This is best evidenced by the fact the savings ratio remains above its pre-crisis levels. 

One other area they may pile in to is property, for which the effect of leveraging up in the short term (even at low rates) may have a damping effect on inflation:

 

So, it may well be that low rates are here to stay for some time.

When we consider the fact household debt stands at £1.4 trillion and the UK government debt is forecast to reach £1.8 trillion by 2016/17, don’t bank on rates shooting up any time soon. 

Indeed, with so much debt reliant on low rates, it’s not inconceivable the Bank of England would tolerate significantly overshooting its target if and when QE does finally work its way in to the wider economy, to avoid a raft of defaults. 

Luke Springthorpe is a finance expert in the City of London. He tweets at @L_Springthorpe


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