Ongoing deflation

This morning the inflation figures were released for September.  They show that the economy is in ongoing deflation, as it has been since March 2009, with the annual change in the Retail Prices Index (RPI) standing at -1.4 percent.  At the same time, the policy index used by the Bank of England to determine its interest rate and quantitative easing policies – the Consumer Prices Index (CPI) – saw its annual rate of inflation fall to 1.1 percent from 1.6 percent.

Some press commentary suggests that the fall in CPI inflation to 1.1 percent suggests there is now a threat of outright deflation next year.  This is wrong.  The country is already in deflation.  The CPI is not a measure of the cost of living in the UK.  In particular, about a quarter of the goods and services covered by the Retail Prices Index are simply excluded from CPI.  The CPI is a policy index used to guide interest-rate setting, rather like the old RPIX measure (“Retail Prices Index Excluding Mortgage Interest Payments”) used until 2003.  The RPI deflation is the better indicator of changes to the cost of living.  We are in deflation now.

There is, however, an outside risk (as there has been for some time) that CPI inflation will soon fall below 1 percent, the lower threshold for CPI inflation below which Bank of England Governor Mervyn King must write a letter to Alistair Darling explaining why the Bank has missed its inflation target by so much.

There is also a material risk that, next year, deflation will become so great that nominal wages will start to fall (i.e. people will start to experience falls in their wages in cash terms).  This could be disastrous as it would probably result in widespread defaulting on mortgage loans and further problems for the financial sector.  It is precisely to counter this risk that the Bank of England’s quantitative easing programme was undertaken and still continues.  Let’s hope it works.

Andrew Lilico is Policy Exchange’s Chief Economist