08 May 2015

What happens when inflation goes into reverse?

Inflation in the UK has dropped to zero for the first time in recorded history. It's likely to go into reverse next. But what does the prospect of deflation really mean for your disposable income, debts and savings?

For the first time since modern records began, prices are no longer rising in Britain. In February and March 2015, inflation as measured by the Consumer Prices Index (CPI) dropped to 0.0%, meaning that the cost of the ‘basket of goods’ that it measures (everything from baked beans to car insurance) was the same as a year earlier. With energy bills likely to drop further as a result of cheaper gas, the cost of living in the UK could soon be decreasing. If so, the country will officially enter a period of deflation.

This is largely uncharted territory for the UK. The last time inflation shifted into reverse here is thought to be in 1960, when JFK was running for office and The Beatles were only just forming. Now though, it seems highly likely that inflation will drop below zero over the coming weeks, and many predict it will hover around zero for most of the year ahead.

What deflation means for disposable income

Falling prices sound like good news – and for many people, in the short term, they could be. It means the cost of daily necessities like fuel, energy and food, as well as products like books, games, toys and laptops are going to continue to get cheaper; salaries will go further and there's going to be more disposable income in everybody's pocket. At the petrol pump and checkout, you'll feel richer than you have in recent years.

What deflation means for pensioners

Pensioners stand to benefit most in the disposable income stakes, because the state pension doesn't just increase in line with inflation. It rises by whichever is highest out of the annual inflation rate, average earnings increases or 2.5%. At the moment, this means the state pension goes up by 2.5% a year. From this month onwards that means £2.85 more per week for every pensioner, all at a time when the cost of living is dropping. Those who have already saved large lump sums, like many pensioners and retirees, will see the ‘real’ value of their money increase. They can look towards a near-future where it will buy more than it does today.

What deflation means for savings

On the one hand, deflation seems like bad news for those trying to build up savings, since falling prices reduce the chances of the Bank of England raising its base rate. On the other hand, any savings account with a positive interest rate is now growing the real value of the money in it, since inflation can't eat into the value of your savings when it's going backwards. Competitive savings rates become more valuable than ever, and more disposable income can also mean that it's easier for people to put money aside. Nationwide offers a broad range of options for savers, whether you need instant access to your money or can commit to saving for longer.

What deflation means for debts

Falling interest rates feel like a boon for borrowers, with plenty of fixed-rate mortgage deals available at low interest rates. However, it's worth remembering that during a period of deflation the actual value of any debt starts to increase. Deflation might mean that you pay less in interest on debts in the short-term; but in the long-term it could mean that your debts feel like a heavier burden. It all depends on how long deflation continues for – and whether it starts to affect earnings as well as prices.

The dark side of deflation

What worries economists is the prospect of a period of deflation becoming entrenched in the longer-term. The theory is that because people know prices are continually falling, they stop buying, holding off from making purchases until they're even cheaper. Businesses end up with less trade and are forced to lower prices and reduce production, leading to bankruptcies. This in turn means cuts in wages and potentially rising unemployment. Economists call this a ‘deflationary spiral’. It's a vicious circle that has undermined Japan's economy for decades and famously led to the Great Depression in America in the 1930s.

Is this kind of ‘bad’ deflation on the horizon? Concerned commentators point to the Eurozone, which is currently experiencing falling prices at a rate of around 0.2 percent each year. However, the Governor of the Bank of England, Mark Carney, has argued that the UK's low inflation will only be temporary because of autonomy over our currency, and also because the main causes of deflation – oil and food – won't keep falling in price indefinitely. Other hopeful signs for the UK economy include rising employment and signs of a pick-up in wages.

This matters because the real impact of deflation on your financial prospects depends on how long it lasts for and how entrenched it becomes in the way that businesses and people think about the future. It will be easier to enjoy the advantages of short-term deflation now if we know it's not going to form part of our long-term future.

Help your savings take advantage of deflation

When prices are falling, a competitive interest rate grows the value of your savings even faster. We offer a range of savings accounts including cash ISAs, fixed and variable interest rate savings accounts. You'll also find lots of ideas for making the most of your money in our Savings Guide.

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