All-Time Low Inflation Poses Big Risks For The Bank Of England

Chancellor George Osborne took to social media to celebrate the news that consumer prices inflation has fallen to its lowest rate on record - 0.5%.

Osborne Tweeted:

However, for the Bank of England falling headline inflation is at best only partly good news as the index is now 150 basis points below the Bank's 2% target. With interest rates on the floor and the effectiveness of further rounds of unorthodox measures such as quantitative easing open to question, falling inflation could pose a big risk for the UK economy. And it is one that the rate-setting Monetary Policy Committee (MPC) would be wise not to ignore.

Given that real wages in the UK (wages adjusted for inflation) have been falling for the past six years falling inflation is undoubtedly providing some much needed relief for hard-pressed households:

Yet most economists were hoping that real wages would start increasing due to stronger wage growth rather than slowing price growth. Instead wage growth remains modest compared to previous recoveries up only at 1.6% in December (excluding bonuses) compared to a year earlier.

The Bank is likely to claim, with some justification, that falling prices are predominantly due to temporary factors such as the collapse in the oil price, which will ultimately fall out of the data as the commodity's price stabilises. Just as the MPC looked through above-target inflation for four years between November 2009 and December 2013, so they could look through a bout of below target inflation by declining to act.

And indeed today's inflation numbers are already clearly showing the impact of the falls. The biggest downward contribution to inflation came from housing and housing services, of which energy and gas bills are a significant part.

The problem is that the lower inflation goes, the higher the risk than any unexpected shock could send prices falling - meaning deflation. If that takes hold it can disincline people from making purchases, as they wait for prices to fall further, depressing demand and slowing the economy just as the UK was starting to show signs of life after years of post-credit crunch stagnation.

More worryingly, if the CPI did fall into negative territory the Bank of England has very limited options for responding as interest rates are still up against what economists call the "zero lower bound". This means that central bankers would have to rely on restarting asset purchase programmes or other unorthodox measures (such as credit easing) in order to try to push inflation back to target.

Since we don't yet have a complete theory for how effective these unorthodox policies work would be in a deflationary environment it means that the Bank is effective taking on risk by not undertaking some precautionary easing now. And with the government determined to close the budget deficit over the next five years, apparently irrespective of the potential risks with rates at the zero lower bound, the central bank is (at least notionally) being forced to shoulder this burden alone.

Of course, a commitment by the government to respond by increasing spending in the case of a deflationary shock could remove this problem. That, however, relies on the Coalition and whoever is in government after May's General Election taking these economic risks of falling inflation much more seriously than they appear to have to date.