Why the UK inflation rate is desirable

With inflation expectations at safe levels, it’s no surprise that many economies would like to have the UK’s inflation rate.

The surprise fall to 0.5 per cent in the annual CPI rate shocked markets and saw sterling decline, however, it’s likely that much of the world are jealous of the UK inflation rate. While many experts are worrying over deflationary risks and debt-deflation traps, most are missing the bigger picture.

Consumers have more spending power

Although there are many severe consequences to prolonged periods of falling prices (deflation), for instance the lost two decades of Japan, the UK economy has yet to experience negative inflation and expectations remain strong enough to support low price growth for a while yet.

This means that wage growth will continue to outstrip inflation, which happened for the first time since 2009 in November last year. Effectively this will put more money in the pockets of the consumer, granting them heftier purchasing power, while effectively cutting the overheads of many businesses.

Core inflation, which excludes the effects of food and energy prices, remained fairly stable at 1.3 per cent in December and has not wandered too far from the Bank of England’s (BOE’s) target of two per cent.

Therefore, it’s most likely that the continuing oil price crash accounted for most of the underlying reasons of the sharp drop in the UK inflation rate.

Low oil prices acts as tax cut

Since June 2014, the cost of a barrel of crude oil turned lower and has declined by around 55 per cent so far, sharing a striking resemblance to the crash that followed the financial crisis in 2008.

Brent crude oil now flirts with the $45 level, which it has already dipped below, and many experts believe we will see prices fall as low as $35 per barrel. Fortunately for the UK, the economy doesn’t rely on oil-related exports for growth, which allows businesses and residents of the UK to enjoy this period of lower prices.

We can also expect the BOE to push back the timing of its first interest rate rise since the base rate was slashed to its historic low of 0.5 per cent, which would be good news for borrowers. A low interest rate effectively makes it cheaper for debt holders and would help those that have yet to prepare for an increase.

However, as the decline in oil prices has yet to fully filter through, it remains a possibility that the CPI rate will drop into negative territory.

Deflation possible, but unlikely

The Centre for Economics and Business Research predicts that inflation will fall to -0.2 per cent in the year to March and even the BOE’s governor, Mark Carney, warned that deflation is now possible in an interview with ITV.

While it is possible, it will take more than current economic circumstances to see inflation falling for three months or more – the economist’s definition of deflation.

Even if we do end up seeing deflation, we can take refuge in the fact that the BOE had enough foresight to keep a few weapons tucked up its sleeve. There remains room for the BOE to either cut rates further or to embark upon another round of quantitative easing, however, the need for this remains unlikely.