Inflation is at a 14-year low in the UK. With oil prices still dropping, it’s likely that it will fall to the lowest levels in decades during the coming months. A lot of people, including me, have made a big deal about how deflation is a bad thing for Europe.
But I don’t think there’s very much to worry about in the UK.
The eurozone was pushed into deflation in December by falling oil prices, but its inflation was a lot lower than the UK’s for a lot longer. Mark Carney is no hawk when it comes to monetary policy, and he called falling oil prices an “unambiguously net positive” factor for the UK at his last major press conference.
That’s because oil prices falling is an example of supply side deflation: When things get cheaper because there are more of them, or they’re easier to make. That’s sometimes known as “benign deflation“. The opposite version is demand side deflation: When goods get cheaper just because people don’t have as much money to spend, and producers are forced to cut prices.
For the UK, the current drop in inflation looks pretty benign. Even if oil prices keep tumbling, the effect can only last so long: Imagine that prices fell to $US40 by February. If they’re still at $US40 in February 2016, then oil would no longer be putting any downward pressure on prices.
There are a number of reasons that the UK is in a better place than the euro area: The UK has better population dynamics than the eurozone, where the population of people aged 16-64 has already started to fall. The IMF have suggested before that an ageing population (and shrinking workforce) can in themselves drive deflation.
Unlike the euro area’s stagnant unemployment, UK joblessness is becoming increasingly rare. The rate has fallen to 6%, down from over 8% at the start of 2012, and it still seems to be falling. That should put pressure on pay packets as employers increasingly have to compete for staff.
Here’s the major difference between the UK, US and eurozone summarised in one chart:
While the eurozone’s nominal GDP (a combination of real economic growth and inflation) has been pretty much stagnant since 2009, edging up and down just a few percentage points, UK and US NGDP is now more than a quarter higher than it was in 2006. That’s a symptom of the fact that the eurozone has had a big demand problem and a fairly ineffective monetary policy. Deflation puts pressure on indebted households and governments, and is made doubly worse when there’s no growth.
Some people are worried about the “second round effects” of lower inflation: people become used to low or no inflation and plan for it. This could hypothetically be a problem for wages, if employers feel less pressure to raise salaries since prices are falling or flat. But could that really happen to the UK just because of a brief spell of oil-driven deflation? Not everyone agrees.
Here’s how Robert Wood, chief UK economist at Berenberg Bank, puts it:
In our opinion, those theoretical risks are overblown for the UK. Consumers will not delay buying a television because it cost them less to fill up the car at the pump, and falling unemployment along with solid growth should mean employers do not get a free ride in setting wages.
The UK economy is still not in amazing health. Some of the UK’s growth has been a little illusory, simply due to the fact that the population has been growing. Wage growth has been stagnant or actually negative for years. Some of the drop in inflation could plausibly be low for demand-side reasons and that would be a bad thing. But there haven’t been many signs that’s the case.
Crucially, if petrol prices and utility bills are falling, consumers are free to buy other things: Oil prices only bring down inflation because their byproducts make up a big chunk of what people buy, and that leaves them with more disposable income to spend elsewhere. The drop in inflation should show up in an uptick in growth, something that certainly hasn’t happened in the eurozone.
The Bank of England looked through above-target inflation for years after the financial crisis, and quite rightly: Rigidly sticking to an inflation target would have been a bad idea when the economy was weak and really needed stimulus. Now, the economy is not weak and further easing doesn’t seem necessary. The Bank is safe to wait and see.