While the significant drop in forecasted inflation for 2024 may seem like good news for many households, experts are warning of potential deflationary risks in the United Kingdom.
Anticipated Inflation Drop in the UK for 2024
In 2023, prices rose rapidly, putting pressure on the affordability of goods and services for households. However, as the year progressed, there was a slight slowdown in the inflation rate, offering a brief respite for household finances.
The Consumer Price Index (CPI) witnessed a 4% rise in the twelve months leading up to December of the preceding year, up from November's 3.9%. This marked the first annual increase in the inflation rate since February 2023, with alcohol and tobacco prices contributing significantly to December's inflation, driven by an increase in tobacco duty.
Lower energy prices and subdued inflation in consumer goods and services are expected to contribute to a decline in inflation in 2024, as predicted by most economists. Additionally, there is an expectation of a decline in household energy prices in April 2024.
However, there remain concerns about the possibility of inflation surging again, primarily due to ongoing conflicts in the Middle East. Recent disruptions in shipping traffic in the Red Sea and Suez Canal could potentially threaten the global economy in the future.
How Close Is the UK Economy to Deflation's Edge ?
Deflation is defined as a general decline in the prices of goods and services, typically associated with contractions in the money and credit supply in the economy. During deflation, the purchasing power of currency increases over time.
Deflation causes a decrease in the prices of labour, goods and services, even though their relative costs may remain unchanged. While it may provide some relief to consumers, as they can afford more goods and services, deflation is a matter of serious concern among economists. In fact, deflation could be detrimental to borrowers who may face higher debts than the amount they initially borrowed, and it can also have adverse effects on other financial market participants.
The UK economy could potentially face deflation due to the Bank of England's assertion that rising interest rates could reduce the demand for goods and services within the economy. This is a consequence of many individuals burdened by heavy debts that eventually catch up with them, leading to a reduction in aggregate demand and, consequently, a decline in the prices of goods and services. There is now a significant likelihood that this scenario may materialize in the coming years, as the impact of high-interest-rate mortgages continues to affect the economy.
Is Deflation Really a Bad Thing?
Deflation indeed brings forth a host of unfavourable consequences, including the following:
- Falling prices, especially when some business costs are fixed, can lead to an immediate decline in business confidence and a simultaneous increase in business failures, as profitability can vanish rapidly.
- With rising unemployment, struggling businesses are likely to implement wage reductions automatically.
- The decline in household incomes can leave them burdened with significant debts, even if interest rates decline. The longer deflation persists, the more challenging their financial situation becomes.
- Borrowing activity tends to decline, along with interest rates.
What Impact Could Deflation Have on Personal Savings and Investments?
The consequences of deflation on personal savings and investments are multifaceted:
If interest rates are reduced, savings would diminish. Sarah Khalaf notes, "Savers would find the boon in rates they have enjoyed for the last year or so would dry up pretty quickly, as would those looking to buy annuities."
Deflation can have a mixed impact on savers. As Vanessa Eve, investment manager at the wealth manager Quilter Cheviot, explains: "On one hand, the value of money saved increases as prices fall, meaning savers can buy more with the same amount of money. This increased purchasing power is a positive aspect of deflation for those with savings. However, deflation often leads to lower interest rates, potentially reducing returns on savings accounts and other low-risk, interest-bearing assets, making it more challenging to grow savings through these vehicles."
For investors, deflation presents challenges. Eve continues, "Generally, deflation is associated with a slowing economy, which can lead to decreased corporate profits and lower stock prices. Investments in equities might suffer as consumer demand weakens, and companies struggle to maintain profitability." However, if the Monetary Policy Committee (MPC) cuts interest rates and the deflationary period is short-lived, stock markets could rebound, provided it is not seen as a sign of permanent economic deterioration.
In a deflationary environment, debts become more burdensome in real terms, potentially harming corporations with substantial levels of borrowing. This could result in lower returns across various asset classes. On the positive side, fixed wages may perform better in times of deflation, as their real value increases when prices are falling.
Which Countries Have Previously Experienced Deflation?
Some countries, including China and Japan, have grappled with the challenges of deflation in the past.
China's Deflation Dilemma and Economic Uncertainties
China has entered another deflationary phase since August 2023, and deflationary pressures are expected to persist for at least 6 months as the property market woes continue to erode confidence in the Chinese economy.
"This is something investors need to be cautious of. The economy here is bad […] it's really bad. I've been in China for 27 years, and this is probably the lowest confidence I've ever seen," Shaun Rein, Founder of the China Market Research Group, reported to CNBC's "Squawk Box Europe".
Deflation, characterized by a decline in the prices of goods and services, is typically associated with an economic slowdown, raising concerns about the growth prospects of the nation. China's post-pandemic recovery has fallen short of some expectations in 2023. Notably, December's pork prices, constituting around a fifth of China's Consumer Price Index (CPI), signalled the possible onset of deflation.
"Deflation is a serious issue. I know the Chinese government doesn't want me saying it, but it's an issue that we need to be worried about," emphasized Rein. "So, I am kind of surprised that they kept the prime rates unchanged. You know, it would have been nice if they had lowered them to try to stimulate the country."