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Are we set for deflation across the nation?

There is a strong possibility that later this year the UK economy will experience its first serious spell of deflation – where average prices are falling rather than rising – in more than half a century.

Last week, Bank of England governor Mark Carney said there was a risk prices could start going backwards in the spring, largely as a result of a fall in the cost of energy and food. The value of oil has roughly halved since last summer due to slowing global demand and a reluctance on the part of the major oil-exporting nations to reduce supply accordingly. The eurozone economies slipped into deflation last month, and it looks like Britain will shortly follow suit.

There are two important questions raised by the current situation. Firstly, is what we are facing “true” deflation? And secondly, is it something we should be worried about?

Although deflation is technically just a fall in typical prices, a lot of experts think that what we are about to experience won’t really count as deflation because it is largely the result of one factor, namely lower energy costs. Carney says that the prices of most items are in fact rising, but the overall average is being dragged down because the fall in oil prices has been so pronounced.

He also points out that in a few months’ time, the slump in oil prices will have worked its way through the system and will no longer register as deflationary – provided crude values don’t continue on their downward trend.

Measures of inflation compare prices today with those a year or a month ago. So if, say, a litre of petrol is 110p today but was 135p last February, it represents a significant fall of almost 20%. If, however, petrol remained at 110p, by next February the inflation rate on fuel (and gas and electricity bills, and so on) would be 0% and the low oil price would no longer have a serious deflationary effect.

So deflation, if and when it happens, may be short lived. But what impact will it have? There are in fact a number of potentially beneficial consequences. If prices are lower, people will feel wealthier, provided wages don’t fall. A rise in consumer spending could give the economy a much-needed boost. Lower energy costs will also help many businesses become more competitive or profitable. In fact, Carney has encouraged firms to share the benefits with employees.

But deflation also raises the spectre of a further fall in interest rates. Although the Bank of England base rate has been at an all-time low of 0.5% for almost six years, the Monetary Policy Committee could cut it even closer to zero. For savers who had been expecting a rate rise at some point in 2015, this could be desperate news – and another prompt to seek a more profitable home for spare cash than deposit accounts and cash Isas.

Only if deflation is allowed to take root will we see serious problems. For example, if businesses react to the first sign of lower prices by cutting wages, this could depress demand and make matters worse. This is the kind of knee-jerk response that Carney is trying to avoid with his recent comments. How successful he will be remains to be seen.