Q&A: What is deflation, and how could it affect me?
Last Tuesday, the Office for National Statistics (ONS) revealed the inflation figures for March 2009. As was widely expected by experts, both the CPI (Consumer Prices Index) and RPI (Retail Prices Index) fell, with the RPI dropping below 0% for the first time in more than 40 years. The CPI now stands at 2.9% for March – down from 3.2% in February. The RPI stands at -0.4%, down from 0% the previous month.
1. What’s the difference between the two measures of inflation?
The CPI is a Europe-wide measure of how fast the cost of consumer goods (such as food, drink and gadgets) is rising, while the RPI takes into account average price changes including housing and mortgage costs.
One reason why the RPI is now significantly lower than the CPI is the recent reduction in many households’ mortgage payments. Some people have seen the cost of their mortgages fall dramatically since last October, thanks to the Bank of England’s aggressive rate cutting policy.
The CPI is the measure which the government has asked the Bank of England to control. Its target is to keep CPI at 2%.
However, RPI is the measure of inflation more often used by the government, trades unions and many employers to calculate the changes that should be made to state benefits and salaries.
2. So what does ‘deflation’ mean?
Deflation is the opposite of inflation, which is why it is usually represented by a negative number.
Deflation means that, overall, prices are falling rather than rising. While this might sound like a good thing, it could have serious consequences.
A prolonged period of deflation could lead to consumer spending slowing further or stagnating completely. That’s because, in an era of falling prices, most people would rather wait for the cost of the goods they need to drop before they buy them.
Over time, this could spiral out of control and have a disastrous impact on the economy, which relies on people’s spending to grow.
However, it’s worth remembering that the CPI is still above the Bank of England’s target. While it fell between February and March, this measure of inflation has not turned negative – so although some economists predict Britain could slip into a dangerous deflationary spiral, this hasn’t happened yet.
3. Will deflation have affect me?
Possibly, because RPI is the measure of inflation used by the government and employers when they adjust state benefits and salaries.
Here’s how deflation might make a difference to you:
Pensioners and people in receipt of benefits
The state pension is adjusted each April in line with the RPI for the previous September, so payments have recently increased by 5%. The government says that the annual increase in the state pension will not fall below 2.5% next year – so even if the RPI is negative in a few months’ time, pensioners should still see the amount of money they receive go up in 2010.
Some other types of state benefit are also linked to the RPI, and therefore rose by 5% at the start of this month. The government has said that, even if RPI is 0% or below this autumn, these benefits will not be cut.
People with incomes from annuities
If you have an index-linked annuity (which pays out a sum that alters in accordance with inflation), you could find your income payments go down this year.
Some annuity providers have said they will not reduce income payments in line with the drop in RPI, but not all have made this pledge. It is worth checking the terms and conditions of your annuity and contacting your provider if you’re in doubt.
Savers
If you hold index-linked savings certificates with National Savings and Investments (NS&I), the return you receive on these will decrease. The rate of interest paid on them is currently 1% plus RPI – but as RPI is now below zero, no index-linking will be added.
Elsewhere, deflation is arguably good news for savers. If the cost of living is generally falling, this means the ‘real’ return on the money you put by increases – despite the fact that the interest rates on offer from many high street savings accounts are at an historic low.
Borrowers
Conversely, deflation is bad news for those with outstanding debts. This is because, as prices throughout the economy fall, the ‘real’ value of what you have borrowed goes up.
If you’re dealing with expensive debts, one way to make pay them off more cheaply and quickly is to transfer them to a credit card or loan that offers a lower rate of interest. Read this article for an explanation of how this strategy works.
Graduates
If you took out a student loan before 1998, the interest rate you pay on your debt will be equal to the RPI.
The rate paid by graduates with these loans is adjusted each September in line with the RPI from the previous March.
As the RPI for March 2009 is negative, it could be that graduates with pre-1998 student loans pay no interest on those debts from September 2009 to August 2010. However, this is yet to be confirmed by the government.
Graduates who took out student loans after 1998 pay a rate in line with either the RPI or the Bank of England base rate plus 1% (whichever is lower).
These graduates are currently paying interest at 1.5%, but as RPI is now below zero this rate could shrink further.
Employees
Finally, it’s worth being aware that many trades unions and employers use the RPI to strike pay deals with employees and adjust annual salaries. This is to ensure workers’ ‘real’ incomes are maintained over time.
Given that Britain is in the grip of recession, the fact that RPI has turned negative is likely to mean many employers freeze pay for their staff.
Alternatively, some may decide to reduce employees’ pay in response to the fall in the RPI and conditions in the wider economy.
4. Is there anything I can do to combat the effects of deflation?
Deflation is a measure of what’s happening throughout the whole economy – so it isn’t something any individual can control.
Furthermore, it’s impossible to know whether Britain is headed for a short spell of deflation (which might help stimulate spending and speed up our recovery from recession), or is in for a longer, more damaging period of deflation.
All anyone can do right now is make ensure their own finances are as shipshape as possible. That means paying down debts, saving as much as possible and ensuring you have the best-value deals on financial products such as energy and insurance.
**This material is for information purposes only and should not be considered financial advice. We strongly encourage our readers not to rely solely on this content, but to seek independent advice when making financial decisions.**
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