Falling prices are good news in the short term, but it's down to us to spend our way out of recession....
Inflation fell at its fastest rate for 16 years in October down from 5.2% in September to 4.5%, a much bigger drop that most experts expected. That’s good news right? Well it is for now, for a whole host of reasons. First of all, the drop has been largely driven by falling fuel and food prices – stuff that we all need rather than luxuries, so we should all feel the benefit. The cost of a litre of petrol came down by 7.1p on average, whilst food staples such as bread, milk and meat all fell too.
So that’s the immediate good news. The other bits of good news might take a little longer to come to fruition, but they will be worth waiting for. First, the sharp drop in inflation gives the Bank of England even greater scope to aggressively cut interest rates, which many believe will fall as low as 1% in 2009.
The recent cut to 3% has now started to work its way into the mortgage market. Rates have fallen sharply, with many lenders offering fixed rates at less than 5% (though still with hefty product fees) and tracker mortgages starting to re-appear on the market having all but vanished in September and October. It’s not all good news though – if you’re a first time buyer, you’ll still need a sizable deposit to get any kind of mortgage, and you’re likely to end up with an interest rate of 6% or more.
It seems likely that interest rates will fall sharply again in December and January. Minutes from the Monetary Policy Committee meeting during which the 1.5% rate cut was agreed show that some members favoured a cut to 2.5% even then. For many observers, that alone signals that a cut to 2% next month is a distinct possibility – those with trackers mortgages must be rubbing their hands with glee. I for one, will be waiting to sort out my new mortgage deal, leaving it until the last minute (but not so late as to end up on the standard variable rate for a month) to see if further interest rate cuts push mortgage rates down even further.
The other news worth celebrating is the fact that a lot of the downward pressure on inflation has been driven by falling oil prices. Ultimately those falling prices will be reflected in lower energy bills. Although they are likely to stay unchanged until the new year, as oil stocks bought at high prices are used up, Scottish Power has already said that it will cut prices in the new year (subject to a list of caveats). If that happens it will be hard to the rest not to follow suit.
So, the good news is that, provided you didn’t fix a mortgage in the last few months and you still have a job, horribly tight household budgets should find some slack in the coming months. But there is a sting in the tail. There is a concern that inflation, which is predicted to fall to 1% or lower next year, could ultimately turn into deflation in 2009/2010 – something we haven’t seen since 1947. In essence, that means that prices will actually fall, rather than just going up more slowly. Great, you might think, but in reality deflation is a destructive economic force. That is, if prices continue to fall business make less money and have to make redundancies. At the same time, the government brings in less in taxes – leaving it with less power to invest in re-inflating the economy. That can lead to a dangerous deflationary spiral – last seen in the 1920s and 1930 during the Great Depression.
Happily, most commentators don’t think it will come to that, ands some even believe that a short period of deflation will be good for the economy. That is, a short burst of price cutting makes us all feel flusher and encourages us to spend money, which is the key to pulling us out of recession. However, if we all sit on our money waiting for prices to fall even lower, then the problems start. Consumer demand is the life blood of the economy, and if it is stripped out, then deflation really takes hold and we are staring down the barrel of a protracted and painful recession.
So, it might seem to defy logic, but in the end it is our willingness to spend money that will revive the economy, helped of course by further interest rates by the Bank of England.
