Why deflation is bad news

Inflation, like interest rates, the instrument used by the Bank of England to control rises in the cost of living, is on the way down.

Interest rates may hit 0 per cent. There are good reasons why it is hoped the rate of inflation does not do the same.

Deflation occurs when, year on year, prices fall. In some industries, deflation is built into the pricing system. Computers, for example, have been getting progressively more affordable.

Deflation across the whole economy may seem like a good thing. Consumers benefit because shop prices and utility costs come down.

But sustained deflation can have a profoundly adverse effect on an economy. To begin with, it does not necessarily encourage consumers to spend. In fact, it can actually postpone consumer spending because shoppers, used to falling prices, wait in the expectation that prices will fall yet further.

This creates a vicious circle as retailers fulfil those expectations by lowering prices in order to attract customers. Manufacturers must then follow suit, cutting their own prices, so leaving less for investment, new equipment and wage bills.

What happens next is that hard-pressed employers reduce wages (there is no inflation to force them up and profit margins are being squeezed by falling prices). As wages fall in value, so consumers become even more reluctant to spend. And prices continue to deflate.

Another major problem caused by deflation is that debt rises in price. Money is borrowed, say, to buy a car. By the end of a deflationary year, the salesroom price of the car has dropped, yet the value of the loan taken out by the customer has not. So debt becomes more expensive. And consumers less likely to borrow in order to spend.

The only benefit that deflation may bring is that savers, struggling to find a savings account that delivers anything like a decent interest rate, can watch as the spending power, if not the actual amount, of their money grows. Put £500 in an account at the start of a deflationary year, and by the end of that year it will buy more than £500 worth of goods.