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Analysis: Is this the start of a deflationary spiral?

In January and February, the word “deflation” was much spoken in the corridors of the City. With stockmarkets hovering around historical lows and sterling still plunging, some feared Britain could go the way of Japan in the 1990s.

Today deflation arrived, as figures revealed the retail prices index fell by 0.4% in March against the same month last year. It is the first time since 1960 that the index has fallen. But the news arrives in a changed environment: a stockmarket rally has lasted several weeks, and a newly appointed member of the Bank of England’s monetary policy committee last week dared to say that “the worst of the recession may well be behind us”.

So how serious is Britain’s period of deflation likely to be?

Azad Zangana, a European economist at Schroders, says month-on-month the RPI exceeded the consensus expectation by remaining flat after analysts predicted it would fall 0.2% against February. Meanwhile, consumer prices index (CPI) inflation fell to 2.9% on a yearly basis from 3.2% the month before, remaining above the target level of 2%.

The RPI’s fall against last year was led in part by falling oil prices after last year’s record highs, a trend set to continue since oil prices did not begin to fall until July 2008. Zangana says the current price, $48 a barrel of crude oil, is “a more realistic level, a sort of pre-Iraq war level. The price at the moment reflects general global trends in terms of growth.”

However, the RPI’s fall also reflects the collapse in the housing market and directly incorporates falling mortgage interest rates, since the RPI – unlike the CPI – includes housing costs.

Zangana says, “While we expect the trend to continue, on the back of falling house prices weighing down on the index, it isn’t yet as serious as it could be if deflation really does settle in.”

A crucial question is wage settlements. Colin Ellis, a European economist at Daiwa Securities SMBC Europe, says: “Headline inflation being negative for a few months is not a huge concern, but you have to look back down the supply chain to wage freezes and weak earnings growth.”

A report from the Labour Research Department, an independent body that caters for trade unions, in March said that the median increase in pay was still 3.3%, although “a minority in the most vulnerable companies and organisations have had their pay frozen this year”.

Unions and large companies base their pay settlements on the RPI, and if wages start to fall there is a risk of a deflationary spiral as consumers continue to hold off on spending. However Ellis says that this is “a downside risk, not the central case”.

Howard Archer, an economist at IHS Global Insight, is gloomier. “Underlying inflationary pressures seem highly likely to diminish substantially over the coming months,” he said in a statement.

“Intensifying competition amid sharply contracting domestic demand and markedly rising spare capacity should undermine companies’ pricing power through the supply chain. Already muted wage growth is now moderating in the face of soaring unemployment and reduced inflation expectations.”

Archer says consumer prices have fallen less in Britain than in the eurozone because of the weakness of sterling. He predicts “a brief period of mild deflation” in consumer prices, but says “the year-on-year decline in retail prices will undoubtedly deepen significantly further.”

Most analysts expect recovery to start in 2010, noting that the Bank of England’s quantitative easing measures announced in February – which aim to boost money supply and have an inflationary effect – will take time to filter through. Ellis says he is cheered by these measures, even if they need to be extended.

“The Bank of England has woken up to the fact that there’s a big gap between demand and potential supply in the economy, and they will do whatever is necessary to plug that gap.”

Beyond monetary policy, can Britain fulfil the broader conditions needed for a return to growth? It is not yet clear whether attempts to boost lending have succeeded, though a report from the Bank today says gross new lending to businesses rose to £12 billion in March, compared with £9 billion in February. However, figures indicate a government programme to buy corporate bonds has failed to get off the ground, says Ellis.

One ray of light is increased export competitiveness. Zangana says “Britain’s balance of payments is in much better order than a year ago. [Currency changes] have boosted income from abroad on assets and investment support, especially those denominated in foreign countries, but it’s difficult to say how that balances against falling demand and worsening conditions abroad.”

Tomorrow’s budget is expected to include large increases in public sector net borrowing, and despite these aiming to reflate the economy, Zangana expects Alistair Darling, the chancellor of the exchequer, to offer a relatively downbeat forecast.

“Focusing on GDP growth, I think the chancellor is going to be quite negative in his forecast – they’ll put the bad news out now ahead of next year’s general election. He probably will announce a return to growth for some time next year.” It will take “some time to get the public finances back in order,” adds Zangana.

In his view, there will be no “sustained spiral” of deflation, and like the other economists, he indicates an immediate panic would be to miss the point. The real question is whether economic fundamentals are strong enough for any green shoots of recovery to take long-term root.


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