UK inflation is now more than one percentage point below the official target for the first time since the Monetary Policy Committee (MPC) was established in 1997. What does this tell us about the outlook for the British economy?
If past precedent had been followed, we could have seen the views of the MPC on this issue yesterday in an exchange of letters between the governor of the Bank of England and the chancellor. These letter exchanges were not very informative in the past – but they will be even less so now. A change in procedure means we now won’t see the letters until the middle of next month.
Some are arguing that 0.5 per cent inflation is a portent of deflation – a damaging and sustained fall in prices. This is a total misreading of the current UK situation. Damaging deflation occurs when spending, wages, prices and asset values are all falling in money terms. But in the UK, money GDP is up nearly 5 per cent on a year ago, house price inflation is 10 per cent and wage growth is picking up and running above price increases.
Instead, we should see very low inflation – driven by lower energy and food prices – as a good thing for the UK economy, and hope it lasts for a while. Since 2007, we’ve seen 36 months in which inflation was more than one percentage point above the 2 per cent target. In the five years 2009 to 2013, inflation averaged over 3 per cent. The resulting squeeze on living standards held back the growth of consumer spending and the economic recovery.
Low inflation is creating a much better environment for consumer spending as the latest figures show. Autumn retail sales volumes were 4.3 per cent up on the previous year and car sales in 2014 were at their highest for a decade.
Inflation could drop very close to zero in the first few months of this year. But after that, I would expect it to creep up to over 1 per cent by the end of 2015 and then rise to 2 per cent or higher – particularly if we see a rebound in oil prices. So the latest figure does not change the medium-term outlook for inflation and should help rather than hinder growth while it lasts.
Historical precedent supports this view. In the 1950s and 1960s – during the UK’s longest sustained economic expansion – the official measure of inflation (RPI) dropped below 1 per cent for 18 months and went negative in seven months. Yet in the years in which this happened, 1954, 1959-60 and 1963, economic growth averaged around 5 per cent as consumers felt the benefit. Similarly, when lower oil prices pushed down inflation in the mid-1980s, this helped underpin the very strong consumer-led growth in the late-80s Lawson boom.
So forget the howls of anguish about deflation. Inflation below 1 per cent, driven by lower oil prices, is good news for UK growth. And it does not undermine the case for raising interest rates sooner rather than later.