Zero inflation means lower interest rates for longer

Last week the Bank of England’s chief economist Andy Haldane told us that the next move in the official interest rate was at least as likely to be down as up – because of the growing risk that inflation would remain well below the 2% target for longer.

So what do inflation figures for February tell us about whether the greater danger is prices that are falling, deflation, or prices that are set to rise too fast?

Well with the official inflation figure announced as a big fat zero – the lowest since records were first properly kept – interest rates look set to be lower for longer, and the official Bank of England rate of 0.5% could even be nudged nearer nought.

So why has inflation vanished?

Well the Office for National Statistics says that the biggest contributors to the drop in inflation from a trivial 0.3% to 0% were food and non-alcoholic drinks, furniture and household goods, recreation and culture (books, games, toys, hobbies and “data processing equipment”).

What is striking is that transport – the price of petrol and diesel – was not a factor this month in the drop in the inflation rate, because oil prices have risen a bit.

So the driver of falling inflation looks to be the strength of sterling, especially against the weakening euro – which is reducing the cost of imports.

The important point is that, for now at least, the fall in the price of food, games, petrol and energy, if it persists for a few months, is good news for most of us – because it increases our spending power and our pounds go further. In other words we feel and are a bit richer.

Bad deflation

But if stagnation in prices were to go on for longer, if it were to turn into fully fledged deflation, that would be worrying.

The point is that if we thought that the price of things we don’t normally have to buy at any particular moment – household goods like washing machines for example, or motor cars – was on a firmly downward path, we would probably defer purchases of those things, and that would depress economic activity.

BBC

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Craig Erlam

Craig Erlam

Senior Market Analyst - UK & EMEA at OANDA
Based in London, Craig Erlam joined OANDA in 2015 as a Market Analyst. With many years of experience as a financial market analyst and trader, he focuses on both fundamental and technical analysis while producing macroeconomic commentary. His views have been published in the Financial Times, Reuters, The Telegraph and the International Business Times, and he also appears as a regular guest commentator on the BBC, Bloomberg TV, FOX Business and BNN. Craig holds a full membership to the Society of Technical Analysts and is recognised as a Certified Financial Technician by the International Federation of Technical Analysts.
Craig Erlam