17.11.08 by Andrew Montlake

Inflation Turns To Deflation

Concerns over inflation are giving way to the spectre of deflation hitting the UK for the first time since 1947.

Tumbling commodity prices, along with reduced consumer demand in a recession, are causing economists to speculate that inflation may turn negative for the first time since the aftermath of World War Two. Although useful for struggling consumers in the short term, a prolonged period of deflation creates a downward economic cycle.

Consumers and companies hold back spending on expectation that prices will continue to fall, falling demand puts further downward pressure on prices and the deflationary spiral gathers pace. Decreased spending has a knock in effect on firms, causing them to cut investment and jobs to exacerbate the recessionary effects of deflation.

Shadow chancellor George Osborne has however attempted to stoke fears that Alistair Darling’s plans to boost public spending to revive the economy will cause a “run on the pound” (as the pound fell to record lows against the US dollar and Euro last week), which will in turn cause inflation and high interest rates. This is in spite of the IMF calling for large injections of public money by leading nations to stave off a severe global recession. Furthermore, most commentators of the opinion that the deflationary factors mentioned above will hold sway, while a weaker pound will help boost exports and ultimately aid the economy.

Financial markets are leaning towards the deflationary argument and pricing in further base rate cuts, while the pound showed gains against the Euro and was stable against the dollar in early trading on Monday. 2 year Swap rates declined to 3.45% at the end of last week while 3 month Libor fixed at 4.18%.

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