Esther An

This article was first published in the March 2015 UK edition of Accounting and Business magazine.

Standing on the forecourt of your local garage filling up the car with petrol is a slightly more pleasant experience these days, at least on the wallet. The price of unleaded fuel in the UK in early February 2015 was 105.9p per litre, with one petrol station in Birmingham charging 99.7p per litre – a price not seen since 2009. Petrol may only be one example of prices going down, but paying less cash in return for a full tank makes it hard to see what is bad about deflation. 

Cheaper fuel, along with lower energy prices, contributed to a drop in the UK rate of inflation of 0.5 per cent in December 2014, down from one per cent in November (as measured by the Consumer Prices Index (CPI)). According to the Office for National Statistics (ONS), the last time 12-monthly inflation in the UK was this low was in May 2000. This is record-breaking, partly because CPI data only goes back to 1989. But even on other measures, you have to look back to the 1950s to find similar stories on price inflation/deflation. Historic stuff. 

The inflation – sorry, the deflation – picture in the eurozone is even more remarkable. Deflation across the 19 countries that use the eurozone currency appears to be gathering pace. In January, prices in the eurozone were down 0.6 per cent compared with January 2014. That was a further fall from December, when the negative rate of deflation was 0.2 per cent.

Good versus bad deflation

While consumers may take cheer from a cheaper cost of living, policymakers and politicians usually take a contrary view, although their distaste depends on the reasons behind the deflation. 

Martin Beck, senior economic adviser to the EY Item Club, makes a distinction between ‘good deflation’ and ‘bad deflation’: ‘Whether deflation is good or bad depends on what causes prices to fall,’ he says. ‘Bad deflation is when economic growth is low and unemployment is high. But in the UK we have got good deflation because prices are falling due to a fall in the price of oil, commodities and foodstuffs. Since we consume and import a lot of those, that is good news for the UK. And it is good news for the real incomes of households because they have got more disposable income and can buy more for their money.’

Alpesh Paleja, the CBI’s head of economic analysis, thinks that a little mild deflation can be good for economic health, mostly because ‘it does have a benefit on consumers, as it boosts purchasing power’. However, it is not such good news for the countries in the eurozone. Beck says: ‘We haven’t seen much economic growth in the eurozone, and we have got high unemployment there. So some of the very low inflation – or even deflation – is driven by the bust economy. At the same time, they are also benefiting from the same factors that the UK is enjoying: low oil prices, low petrol prices, falling commodity prices. So whereas arguably in the UK the negative inflation is good, in the eurozone some of it is good and some of it is bad.’

Iyanatul Islam is an economist at the International Labour Organisation (ILO), an agency of the United Nations whose objective is to promote rights at work. He points out that while general eurozone deflation was -0.2 per cent, ‘in recession-ravaged Greece, prices are declining at a rate of -2.5 per cent. And that is the problem; deflation is seen as a symbol of economic collapse.’ Islam adds: ‘From a lay person’s perspective, deflation might be seen as a boon, as falling prices boost purchasing power. [However,] mainstream economic analysis perceives falling prices as a bane rather than a boon. This is because expectations about key macro-variables – the inflation rate, growth, etc – drive current private-sector spending decisions. Expectations of falling prices induce workers to hold back spending decisions, and this acts as a drag on aggregate demand.’

Lessons from Japan

Few in the West have experience of falling prices, so it is hard to predict whether we really would stop buying cars and furniture now in the expectation they would be cheaper next month. Our collective experience is just the opposite: in the 1970s, rising oil prices were accompanied by severe recession and surging inflation. Slaying inflation became the overriding political task. 

But Japan provides a worked example of what happens when the opposite problem – deflation – takes hold. A major asset bubble burst at the start of the 1990s. In turn, this set a cycle of depression and deflation from the mid to late 1990s, the effects of which are still just about felt today. Accountant Richard Naish runs a mentoring/training company based in Nottingham in the East Midlands but, with family and business ties with Japan, he has seen the effects of deflation at first hand. 

Naish points out that the Japanese have adapted to the phenomenon of prices going down, and deflation has its limits. ‘Expensive luxury goods did not drop in price even under deflation,’ he points out. ‘But for everyday non-perishable items everyone, even the wealthy, now shops first at the ¥100 shop – the equivalent of the pound-shop – and there is no shame in doing so. What you can’t get there, you go to other shops for. Everyone is more cost-conscious.’

It has also changed other social attitudes. ‘With the post-bubble economy, the job for life started getting rarer,’ says Naish. ‘Now, with deflation, a new social group has evolved, called the “freeter”: younger people who don’t have a full-time job but get a bit of part-time work here and there, and earn just enough to pay for a low-cost living style that is now available under deflation. With the extra time, “free time”, they do things that interest them more, whether that is creative, gaming or just hanging out with friends and having a chilled lifestyle.’

Naish points out that the Japanese have a different attitude to much of the West when it comes to the culture of personal debts and savings. ‘The Japanese had cash saved up diligently for no good reason apart from good self-discipline and self-restraint – the antithesis of the “have-it-now” mentality that is so strong in UK,’ Naish says. ‘So they could weather the lack of salary rises for a while. It remains a question whether Britons have such a buffer to ease any initial discomfort over deflation.’

Time to adjust

But it is unlikely the British will have to test their resolve. Beck says: ‘We are entering an era of low inflation – inflation this year in the UK will be zero, with price falls in the first half of the year and inflation expected to pick up in the second half of the year.’ If this is an era of low inflation – even if not outright deflation in the UK – then businesses and workers are going to have to adjust. ‘Businesses have traditionally planned their operations on the basis that prices are going to be rising and the revenues are picking up,’ Beck says. ‘If we are living in a world where price rises are going to be very low or non-existent, judging company performance will not be done on turnover rising. You are going to focus more on what you are going to do to cut costs and costs margins by keeping costs down. It is a different world in that respect.’ 

Consumers like buying petrol that is cheap; they like it less if employers want to talk pay and deflation in the same sentence. ‘If deflation becomes entrenched, there is a risk that it starts to filter into areas such as wages,’ Paleja says. ‘If prices fall, companies may seek to slow wage settlements. And while wages can be quite slow to adjust downwards, it is certainly a possibility. If you get an unholy alliance of falling prices and falling incomes, then governments will feel the effect in terms of reduced tax revenues, and that can certainly happen.’

Governments also hate deflation because it takes away one of their biggest weapons in sorting out the public finances. The effect of inflation on government debt is the same as a small default, except no angst. ‘Deflation significantly raises the real burden of debt,’ Paleja continues. ‘The debt becomes a lot more expensive to service and paying off the capital is also harder. With deflation, real interest rates are higher so the cost of servicing the debt is also higher. Deflation makes paying down debt much more difficult.’

And of course it is not just governments that borrow. Islam says: ‘Deflation increases the real value of the debt held by private companies and the public sector, and thus constrains the ability of both sectors to repair balance sheets that were impaired by the 2007-2009 global financial crises. This in turn slows down the resumption of sustainable growth, as economic agents are unable to embark on normal spending plans.’

Paleja notes that once it takes hold, action available to deal with deflation is limited. ‘The policy response, from government and central bankers, can be quite difficult,’ he says. ‘You can cut interest rates down to zero but no further. Once you have done that, what do you do?’ 

The risk that we all just sit on our hands waiting for prices to come down even more is not a palatable way ahead. Business leaders along with government will need to react to this environment, and finance directors will need to think constantly about cost. ‘There is definitely less waste on the big “salaryman” entertaining and taking taxis home after working late,’ Naish notes. ‘Everyone is more cost conscious than in the bubble days.’ 

But he adds that there is still a desire for quality, and that can lead to business innovation. ‘Uniqlo is an example – a Japanese brand selling cheap, fashionable clothing made in China, but made to exacting Japanese quality standards.’ Indeed, Uniqlo was described by the Financial Times as ‘a poster child for consumer-price deflation in Japan’. 

Tough sales, uncertain times

But it seems to be the exception in terms of success stories. Different business sectors will be hit in different ways. While motorists can afford to smile, oil companies are smarting. Both BP and Shell have announced plans to slash billions from their capital expenditure programmes and have enacted large-scale redundancy programmes, providing a tough reminder of the other side of price falls that has seen oil collapse from US$115 a barrel in June 2014 to US$50 in early 2015.

Paleja suggests that CBI members could take advantage of falling fuel and other commodity prices by rebuilding margins that have been put under strain in the last few years – although sectors such as retail already wilting under the heat of intense competition may just use falling input costs as another weapon to try and entice consumers into their stores or onto their websites. And those involved in export markets – especially into the eurozone – have to deal with appearing to be more expensive thanks to currency movements at a time when no European buyer is in a financial or psychological mood to accept higher prices. 2015 looks set to be a heady brew of tough sales in uncertain times. 

A few years ago, it was fashionable to talk about the Goldilocks economy: neither too hot that it would crash, nor too cold that recession would take hold. In a similar way, policy makers and central bankers are aiming for nice, steady inflation of two per cent or so a year so government, business and individuals can all plan sensibly and rationally. But that is not the story at the moment, Islam says: ‘The European Central Bank has to rely on unconventional monetary policy interventions – such as quantitative easing – but their effectiveness in increasing inflationary expectations and growth is uncertain.’

Still, amidst all the uncertainty, if you’re looking for an upside, it is unlikely that visiting Japan will ever be such good value again. Naish says set lunch in a decent sit-down restaurant is ¥800 or £4.50 in central Tokyo. Could Paris or Berlin go so low?