The UK has now experienced deflation for the first time since records began in 1996. The Office for National Statistics believes that the last time the UK experienced deflation was in the 1960s.
This was so long ago that you may well be asking yourself “What exactly is deflation and what does deflation mean for our economy?”.
Inflation v Deflation - What's The Difference?
In very simple terms, inflation is when the overall cost of living goes up and deflation is when the cost of living goes down. The word overall is important because prices of different items can go up and down at different times.
How Is The Overall Cost Of Living Measured?
There are two main measures used for determining changes in the cost of living. The older method is called the Retail Price Index (RPI). This was introduced in June 1947. The newer method is called the Consumer Price Index (CPI) and was introduced in 1996.
Both systems use an “average basket of goods” to keep track of how much “average consumers” are spending. In other words, they select a range of items which they think most people need (or want) to buy. They then track the prices of these items.
There are, however, important differences in what they track. For example, the RPI includes the cost of housing (including the impact of Council Tax) but the CPI doesn't. They also use different methods for calculating the average.
Summing all this up in a nutshell, the CPI is almost always lower than the RPI.
Can Inflation Be Managed?
It's the Bank of England's job to try. The BoE runs the Monetary Policy Committee. This has the job of achieving exactly 2% inflation per annum.
Of course, that's a difficult job so the Bank gets a bit of breathing space. The government accepts inflation of between 1% and 3% per year.
If, however, inflation goes either higher or lower, the BoE is called upon to explain itself. The Governor of the Bank of England, must provide a public, written explanation of why it missed its target.
It must also advise the government what it intends to do to get back on target. The BoE's main tool for managing inflation is the use of interest rates. In very basic terms, raising interest rates encourages people to save. Lowering interest rates encourages people to spend.
Why Does The Bank Of England Try To Keep The Cost Of Living Going Up?
In very simple terms, deflation has much the same effect as waiting for the January sales to buy Christmas presents.
Customers assume (rightly or wrongly) that the item(s) they want will be cheaper after Christmas so they wait until then to buy them.
Extended periods of deflation can essentially become a time of Mexican standoff. Buyers get used to seeing prices dropping so they put off making purchases to get lower prices.
Unfortunately this can put producers (and retailers) out of business. Over the long term, this reduces supply and can stimulate inflation. In the short term, however, it can lead to painful redundancies.
Right now, for example, low oil prices are leading to layoffs in the oil industry.
So Is Deflation Automatically Always Bad?
That is an interesting question. It's possible that some deflation on essential items such as food and utilities might actually be helpful. It would give hard-pressed families a respite.
It might even be enough to free up money for other purposes. For example, it might allow families to pay down debts. It might allow them to treat themselves to some non-essential purchases.
The question would be whether or not the end producers would be able to support deflation for any meaningful length of time. If not, then the pendulum could swing the other way towards high inflation – and cause a lot of pain in the process.