Inflation Falls By Less Than Expected

Inflation has fallen by less than expected, but we still need to fight the threat of deflation.

The consumer prices index (CPI) fell from 3.1% to 3% in December. That was higher than expected as economists had expected a rise of 2.7% according to a Bloomberg survey.

The Retail Prices Index (RPI) - which includes housing costs - tells a similar story. It rose 0.1% in January whereas some commentators had expected a fall.

Deflation

So will inflation (rising prices) turn into deflation (falling prices) later this year?

Well, that's what many pundits have been fretting about for the last few months. In fact, I worried about it last September when I said: `The biggest risk for us all now is deflation. Let's hope that central bankers and governments can inject enough cash into the system to stop that happening.'

Central bankers have certainly made a big effort since then to stop deflation taking root. Interest rates have been aggressively cut in both the US and UK, and central bankers are now moving to the next two steps:

- Borrowing money to buy financial assets such as bonds

and then

- `Quantitative easing', where central banks create fresh money electronically, and then use that money to buy financial assets. This step is sometimes known as `printing money', but in the 21^st century, central banks won't literally print extra notes.

Trouble is, it normally takes a year or so before the results of interest rate cuts are clear. So even though today's numbers are encouraging, we don't know for sure whether the recent rate cuts have done enough to stop deflation. All we can say is that Charlie Bean, deputy governor of the Bank of England (BoE), seems to think that further measures are required.

And I think Mr Bean is right. If the BoE creates too much money, the risk is that inflation will come back. But if the BoE is too tough, the risk is that we will get persistent deflation that will last for more than two or three months.

And once you get serious deflation, an economy can head into a `downward spiral.' Consumers are reluctant to buy goods because they think products will be cheaper in three months' time. Retailers then cut prices further to lure customers in, but the customers then expect even greater price cuts, and demand in the economy drops. Then we could have an economic slump.

Yes, today's inflation numbers were higher than expected and that suggests the risk of persistent deflation is falling. But the risk still remains.

And for me, the risk of a serious economic slump is more worrying than renewed inflation. If inflation starts to rise quickly, the BoE can apply the brakes via a higher base rate. That's not an ideal scenario as a higher base rate could stamp out any early signs of economic growth. But I'd rather apply brakes to an early economic recovery than experience a serious depression.

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