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Zero inflation is good news. For now.

    Today’s news that inflation has fallen to zero, the lowest since current records began, is good news. This does mean that the UK is now likely to see a period of deflation in the coming months. The closest comparable data suggests that the last time the UK experienced deflation was in 1960.

    However, as the ONS makes clear in its report, the current downward pressure on prices is being driven by the supply-side. The most significant contributor to the falling inflation is the fact that commodity prices have fallen and most notably the oil price has halved over the last nine months. This is the result of increased Saudi-driven supplies and subdued demand from China and elsewhere. In addition, competition amongst the Big Four retailers and challengers such as Aldi and Lidl has placed downward pressure on the prices of household goods.

    These reduced commodity price pressures and heavier supermarket competition have fed into lower business operating costs and ultimately lower fuel costs. Indeed, food prices fell by 3.4% over the year and motor fuel prices fell by 16.6%. Given that the nominal growth in average weekly earnings is at approximately 2%, the fall in inflation will provide a positive boost to real incomes. The result should be greater household confidence and stronger consumption growth. The combination of this with wider profit margins should also have an accelerator effect on investment which would obviously have longer term benefits.

    It is still unlikely that deflation will persist. The effects of the oil price fall on inflation will diminish and there should be a gradual return to slightly higher price rises. Also, because pay agreements are usually at fixed intervals, there is some stickiness to nominal wages which means that they may not adjust to deflation before prices start to rise again. Furthermore, core inflation which excludes some goods such as energy and food with volatile price movements is running at 1.2% and house prices still grew by 8.4% in the year to January. We are far from a deflationary spiral or picture of disaster predicted by some.

    Nevertheless, as I argued in CityAM yesterday, it is important to ensure that deflation does not become self-reinforcing. Inflation expectations have fallen, although they are still firmly in positive territory. If the deflation persists and becomes entrenched, then nominal wages will likely fall along with household spending, especially as it would also mean a rising real debt burden. Given that household budgets remain precarious for many and there is still spare capacity in the economy, such a development would of course be dangerous. In this unlikely scenario of entrenched deflation, further monetary easing from the Bank of England, probably through heavier QE rather than another interest rate cut, would certainly be feasible.

    That being said it is worthwhile remembering that the fall in inflation has been driven by what seems to be temporary factors. Most households will simply enjoy the easing pressure on their budgets while it lasts - so they should. 

    Adam joined the Centre for Policy Studies as Head of Economic Research in January 2014. 

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