It’s difficult to remain relaxed about the outlook for inflation in the UK given today’s strong CPI and RPI numbers (all above expectations), but, if oil is still at $145 a barrel, and food prices remain at these levels in a year’s time, we’ll be facing deflation. Not because these elevated prices levels will cause a collapse in consumer spending and reduce the demand for discretionary goods – though that too will happen – but because of simple mathematics.
Core inflation, which strips out food and energy prices, is at 1.6% in the UK. It’s been at, or about, this level now for 7 years, averaging 1.4%. Headline inflation is at 3.8%, above the Bank of England’s target because of the strength of the food and energy component. Food accounts for 10.9% of headline inflation, and energy is 7.3%. Put together then, food and energy are 18.2% of headline inflation. Now let’s assume that oil stays up at $145 for the next year, and that food prices also stay at current levels. Although those prices will still be hurting us as consumers, the food and energy inflation rate will fall to 0% – it’s all about the year on year comparisons. Now let’s also assume that core inflation keeps rising at its seven year average rate of 1.4%. Simple maths shows that if core is 81.8% of the headline rate, and is increasing at 1.4%, and the remaining 18.2% is at zero, then the headline rate of inflation in the UK in a year’s time could be as low as 1.1%.
The Governor of the Bank has to write a letter to the Chancellor if that headline rate falls below 1%, explaining why he is allowing the economy to flirt with deflation. If the oil price starts to come off, perhaps in response to the slowing global economy, then that letter might just get written at some point in 2009, and we’ll be asking ourselves how a major modern economy copes with deflation – just don’t ask Japan, a decade after its own bubble burst it’s only now starting to move back into positive inflation, albeit tentatively.