Inflation falls to 0%: what does it mean for the UK economy?

With average earnings growing by just under 2%, living standards should rise and interest rates should remain low but it’s not all good news

Larry Elliott in The Guardian

Britain is within a month of a period of deflation. When the figures for March come out next month lower energy bills mean that the cost of living will be lower than it was a year earlier.

These are uncharted waters for the UK, at least in the modern era. There have been times when inflation has turned negative but they have been few and far between since the second world war, and there have been none since the move to the consumer prices index as the preferred yardstick.

The general assumption is that this is good news, for two reasons. The first is that the fall in inflation boosts living standards, because wages are rising faster than prices. Wages have risen extremely slowly since the recession of 2008-09 and even against a backdrop of falling unemployment are currently only going up by 1.6% a year.

But the sharp drop in oil prices in the second half of 2014 has pushed inflation lower and meant those modest wage increases now stretch further. This is clearly welcome news for the government, eager to fend off Labour’s accusation that the coalition has presided over a cost-of-living crisis. The opposition will say that the recent increase in living standards does not make up for the earlier falls.

The second boost to consumers comes from the outlook for interest rates. It will come as no surprise to the Bank of England that inflation now stands at zero, and the Bank’s governor, Mark Carney, has said it would be “foolish” to cut the cost of borrowing in response to what is thought to be a temporary fall in commodity prices.

That said, the Bank is not going to be in a hurry to raise rates either. All nine members of the Bank’s monetary policy committee are in favour of official interest rates remaining at 0.5%, which is where they have been since early 2009. They look like remaining there for the rest of this year, and one MPC member – Andy Haldane, the Bank’s chief economist – says he can contemplate voting to cut borrowing costs.

That’s because there’s a potential dark side to the fall in inflation, namely the risk that it becomes a permanent feature of the economic landscape. The reason the majority of economists view February’s zero inflation as benign is because they think lower unemployment will put upward pressure on wage settlements. Higher pay deals will start to push up inflation at a time when last year’s drop in oil prices starts to unwind. There is, on this view, little prospect of deflation becoming embedded, as it did in Japan.

This, though, assumes that wage settlements are not dragged lower by the drop in inflation. The fact that average earnings are growing at an annual rate of below 2% even after two years of a relatively robust period of growth is indicative of a labour market where employers are able to secure workers cheaply. They may be tempted to be even less generous once inflation goes negative.