Q&A: UK remains on the brink of deflation

UK inflation has stayed at zero in March, unchanged from February and the lowest rate for at least half a century. This leaves open the possibility that Britain may experience a bout of deflation in the coming months.

Not necessarily. Economists tend to be wary of deflation as it generally accompanies a period of slow growth or even depression. Falling prices can cause shoppers to postpone spending, as they expect goods and services to be cheaper in the future. Companies may then hold back from investing, pushing the economy into a deflationary spiral.

Most analysts say, however, a bout of deflation could actually be good for Britain. Falling prices are partly the consequence of the slump in the cost of oil, which has halved since last June. Cheaper petrol has meant families already have more money to spend elsewhere.

While economic activity has slowed somewhat since the end of last year, retail sales are booming, showing consumers are not holding back from spending more.

No. The oil shock is pushing inflation down in many oil importing economies. In the eurozone, for example, prices have already fallen 0.1 per cent in the year to March, having slumped as much as 0.6 per cent in the 12 months to January. Switzerland is also in deflation, with the consumer price index sliding 0.9 per cent in March.

This does not mean, however, that deflation in Britain would be the same as on the continent. For example, expectations of future prices in the eurozone are rising more slowly than they are in the UK. This means that the single currency area is at greater risk of falling into the kind of "bad" deflation that economists want to avoid.

Analysts are not sure, as there are many different factors at play. One is the behaviour of the sterling exchange rate, which has appreciated sharply against the euro since it became clear the European Central Bank would launch a programme of quantitative easing to boost growth in the single currency area.

A stronger pound against the euro means imports from the eurozone are going to cost less. And since the currency bloc is Britain's foremost trading partner, sterling's appreciation is bound to have a large effect on prices, pushing them even lower.

However, the dominant issue is what happens to the oil price and here, the only way seems to be up. The cost of crude appears to have stabilised and economists expect inflation to pick up again as soon as last year's oil price fall drops out of the 12-month comparison.

Political uncertainty ahead of or after the May 7 UK general election could also weigh on sterling, which would push up inflation.

In theory, with inflation well below the BoE's 2 per cent target, the interest rate setting Monetary Policy Committee should be slashing interest rates.

This is unlikely to happen, however. The MPC's collective view is that the UK is experiencing a bout of "good disinflation" and that prices will return to their normal growth path once the effects of the oil shock are over. Hence, the MPC is united in keeping rates on hold.

Andy Haldane, the BoE's chief economist, said in a speech last month that he thought interest rates were as likely to go down as up. He seems to be alone on this, however. Mark Carney, governor, has said the most likely trajectory for interest rates was a gentle increase and even David Miles - once considered the committee's arch-dove - has said he agrees with this view.

Britain's governing coalition has repeatedly tried to make political hay out of the fact that the cost of living has risen more slowly since the summer. "Low inflation due to falling oil prices is good news for family budgets," tweeted chancellor George Osborne last month when inflation hit zero.

Abating price pressures have created a problem for the opposition Labour party, which has based its campaign on the so-called cost of living crisis. With inflation falling, even a modest pick-up in nominal wages is enough to improve living standards.

Yet living standards remain no higher than before the crisis. This means most workers are unlikely to feel substantially better off even after the recent rise in real wages.

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