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The effects of slowing inflation

Could static, or falling, prices become the “new normal”? The answer is that no one knows. Although the widely cited, and well respected, Ernst & Young Item Club believes inflation will drop to zero on average this year. If that trend goes long term, our finances will need a total rethink.

Inflation (rising prices) has been the norm for around 70 years. Prices have doubled since 1990, gone up 20 fold from 1960 and stand 35 times higher than in 1947. In the 1970s, some salaries increased monthly as the cost of living soared. For most adults, prices today bear no resemblance to those of their childhood. But in 1900, the price of staples such as bread and beer were easily recognisible from 1800 or even 1700.

Inflation is now down to 0.5 per cent. That equates to prices doubling around every 144 years. And forecasts suggest prices falling this year (deflation). On balance, that will be positive for some, negative for others. It all depends on your personal mix of borrowing, saving and investing, and spending. In the past, inflation has benefited borrowers, punished savers, has been good for equities and bad for bonds. Deflation turns those assumptions upside down.

Economists mostly see deflation as bad. They say it brings stagnation – or worse – as spending is put off until a cheaper “tomorrow”. They have a point. Why would shoppers – and we live in a consumer led economy – buy something today which will soon cost less?

Quotation MarksInflation has been the norm for around 70 yearsQuotation Marks

But so far, falling inflation has been driven by oil (and other commodity prices) collapsing and increased supermarket competition. We cannot defer these purchases – who puts off a car journey hoping petrol will be cheaper soon? There's been effective deflation for years in electronics, thanks to rising specifications. Digital gadgets still sell.

Where the economists' argument applies is with goods we can put off buying – furniture and cars are examples, although neither is not a “known value item” (like milk). Worse, it can affect company investment decisions such as new machinery.

But cheaper fuel and groceries mean more to spend. It's like a tax cut, making us better off.

Yes, price falls are bad for the oil industry. Exploration slows, while many “fracking” projects could become uneconomic. And lower oil prices are bad for HM Treasury because tax income plummets. But they could be good for overall employment. Goldman Sachs believes the US will create 300,000 more jobs this year, due to oil costing under $100 a barrel [1].

Inflation in the 1970s to the 1990s was the home buyers' best friend. Mortgages stayed the same, but were paid back in devalued money. A £10,000 mortgage in 1970 cost around £1,500 (in 1970 values) to repay 20 years later. Despite high interest rates, buyers could often repay huge chunks of capital – many could afford to upscale homes every eight to ten years.

Deflation, admittedly with low interest rates, works in the other direction. It's bad for those with longer term debts such as mortgages and student loans. And it is harder to argue for a wage rise – some salaries could fall.

But it's brilliant for those with savings, which will buy the same or more tomorrow and for retired people on fixed incomes and annuities. If deflation becomes the new normal, those interested in inter-generational transfers will note that the winners from high inflation during the last third of the twentieth century, will now also gain from falling prices.

In general, deflation is good for bond investors, less good for shares as profits will be harder to achieve. Fund managers will have to take more care in picking stocks, downplaying the oil and mining companies which dominate the FTSE 100 Share Index and finding companies with a real growth narrative.

The only certainty is that if deflation is the “new normal”, all the economic "sure things" of the post war period will need rethinking.