Deflation Risk Is Bad News For Savers


Currency20.10.14

The Bank of England published its quarterly 'Inflation Report' last week and the Governor, Mark Carney, said that inflation was expected to fall to zero later this year and that interest rates may be reduced below the current level of 0.5 per cent for a short period to help ensure that Britain does not enter a period of deflation.

The report reiterated that the Bank of England's target annual inflation rate remained at 2 per cent. It predicted that inflation would fall to zero as the benefits of lower energy prices continued to be passed on to consumers. It pointed out that the sterling price of Brent crude oil had fallen by 50 per cent since the middle of 2014, leading to a sharp fall in fuel prices. However, it predicted that oil prices would begin to rise again soon and the Bank assumed in the report that oil prices would settle at around $70 per barrel.

The Bank also argued that lower oil prices and the ECB's programme of quantitative easing would stimulate consumer demand in Europe and this would benefit the UK. It also expected strong consumer spending in the UK during 2015 as consumers spent the savings that they were making on fuel and food. In addition, lower inflation was expected to mean that most people in paid employment in the UK would benefit from real wage increases in the current year, which would further stimulate spending. As spending increased, the Bank predicted that prices would start to rise again and that would be the signal for interest rates to go back up with the predicted level of interest rates being 1.5 per cent within three years.

 

That all sounds very positive, but there are a number of factors which may result in the Bank having to revise its forecasts in the coming months. One concern that many economists have is that the ECB is not doing enough and that its programme of quantitative easing will not be sufficient to help Europe avoid deflation. If deflation begins to entrench itself in Europe, then there is a serious risk that this may spread to the UK. Once true deflation begins (not just inflation coming down because of weak oil prices), it can be very difficult to overcome as Japan has seen over the last two decades.

Another factor is the slowing growth in China, which could result in the Chinese opting for a meaningful currency depreciation in order to boost growth. Cheap Chinese imports flooding into the rest of the world would further reduce inflation. Finally, the attitude of the Saudis to the oil price has never been seen before and seems to be aimed at trying to undermine shale gas producers in the US. Thus, it is difficult to predict with certainty that the oil price will bounce and maintain a higher price level.

Does it really matter that much if prices decline? It is very difficult for economies to grow if there are no price increases and given the level of global debt, it would be a disaster at this stage if we hit a period of widespread deflation. The McKinsey Global Institute recently published a report, which pointed out that since 2007, global debt has risen by $57 trillion, representing an annual increase of 5.3 per cent. To put this in context, global debt rose annually by 7.3 per cent between 2000 and 2007. Much of the rise post 2007 has been due to government bailouts of banks, but it is still concerning that the debt position has continued to deteriorate. One means of helping to ameliorate debt is to allow inflation to rise, which reduces debt in real terms. If there is no inflation in the system, you are left with the burden of the debt.

The outlook for the global economy and the UK economy remains uncertain. One thing that is for sure is that interest rates will not be rising for a while longer. Indeed, as stated above, Mark Carney said that he expected interest rates to fall further from the current level of 0.5 per cent in order to help combat deflation. For savers, this is further bad news as they struggle to get a decent return on their cash. For those looking to lend money to companies through Money&Co., it is an additional incentive to build their loan portfolios.



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