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The dreaded R-word, for recession, could soon be superseded by the potentially far worse D-word, for deflation.
A combination of tumbling oil and food prices and an economic recession is threatening to push inflation into negative territory, or deflation, in Britain and other countries around the world. This is an abrupt reversal of the situation earlier in the year when surging commodity prices pushed UK inflation up to a 16-year high of 5.2% by September and petrol prices up to £1.20 a litre.
General deflation is defined as continually falling prices of many goods and services, just as inflation is the direct opposite. So why is deflation something to be feared? If prices start to fall, won't everyone be able to afford to buy more and the poorest people be better off?
The problem is that, faced with falling prices, people hold off buying things, leading to falls in demand and output. Then firms, selling less, cut what they pay to staff. They have less to spend and the deflationary spiral kicks off.
The question now is whether Britain, as it enters recession, is likely to see a few months or a year of falling prices, or whether it will fall into a general spiral of downward prices and wages.
The Bank of England governor, Mervyn King, acknowledged on Wednesday that deflation was now a real possibility, especially for the retail prices index (RPI), which includes mortgage interest payments. These will be dragged down rapidly by the Bank's interest rate cuts. Economists say that a short period of deflation would not be a disaster, but a longer period would.
"A short burst of deflation driven by falling commodity prices would have positive effects on the economy by boosting confidence and spending power," says Jonathan Loynes at Capital Economics. "But there is a clear danger that the huge amounts of spare capacity created by the recession prompt a more prolonged period of falling prices further ahead."
Shops
Retailers can cope so long as sales volumes keep powering ahead - flat-panel TV sales doubled last year and laptop sales were up 50% despite falling prices.
The problem comes when prices fall and sales volumes don't increase because consumers are out of work, have lost confidence and are delaying purchases until goods are cheaper - or vital. Retailers' margins will decline and they will react by axing staff or cutting hours. Argos has already reduced staff hours by 20%. Eventually stores will be closed down.
Another problem is rising purchase costs. All goods brought in from China are paid for in dollars, which will become more expensive as sterling falls. But there is little chance of passing on those rises if consumers won't even buy when prices are falling.
Pay
A short burst of deflation does not necessarily spell bad news for wage earners - provided they are able to keep earning. Lower prices could restore some purchasing power to people who have received below-inflation pay awards.
The risk is that deflation becomes embedded in the economy. Workers feel insecure about keeping their jobs and respond by cutting spending. Even if they are prepared to spend, they may find it more difficult to obtain credit.
Wage bargainers will also find it more difficult to push through claims for higher wages and could be confronted with demands for pay cuts.
Companies/industry
After living with soaring commodity and energy costs, will manufacturers greet a touch of deflation with a sigh of relief? Unlikely. Commodity prices are falling because demand for finished products is falling. Just ask the car industry.
The problem is illustrated in one sector already suffering a severe bout of deflation - housebuilding. Prices have fallen sharply as banks and building societies have become reluctant to lend to homebuyers. The reluctance to lend has been coupled with a reluctance to buy. Why purchase a new house now when forecasters say the price will be lower in a few months' time?
As prices for both materials and finished products fall, the main questions for companies is how hard their margins will be squeezed in the process and how they will be able to control other costs. The rate at which firms are shedding jobs or announcing short-time working is already accelerating and deflation is likely to increase the impetus.
Pensions
Pensioners have fixed incomes - at least most of them do - and inflation devalues every pound in their pocket. So in the sort-term pensioners are the winners from deflation, since they can buy more with their fixed incomes. If they have a private income from a personal pension or occupational retirement scheme it will be paid from an annuity. At the moment, annuity rates translate savings of £100,000 into a lifetime income of just over £5,000 a year - less if inflation-linked rises are built in. Deflation brings low interest rates and depressed stockmarkets, but they do not worry pensioners because annuities provide a guaranteed income. The problem comes if the government prints money to head off deflation. In a year or two that could trigger a return of inflation, even hyperinflation, which will destroy cash savings and devalue pensioners' fixed incomes.
Savings
Savers suffer on all fronts. Interest rates fall on their cash savings. If savers look for racier routes to earn money they will come unstuck. As a shrivelling economy depresses corporate profits, stockmarket investments track downwards. With property prices falling, anyone who owns a house is already suffering deflation on one of their main assets.
The only silver lining is the state of the banks. As long as they need cash to bolster their finances they will be under pressure to offer high savings rates. Cash savings are paying well at the moment and this situation could persist regardless of deflation and the parlous state of the economy. Only hyperinflation could undermine this tactic. When inflation returns it will be the stockmarket that will recover first, in anticipation of a recovery in corporate profits. Savers will need to pick their moment carefully when switching from cash to shares.
Bleak times
The last time the published inflation rate went negative in Britain was in 1947, when the country nearly ran out of food and fuel in the aftermath of the second world war. The winter was one of the coldest on record. The Met Office said that from January 22 to March 17, snow fell every day somewhere in the UK. As the temperature seldom rose more than a degree or two above freezing, snow accumulated until early March. The year also saw the inception of the International Monetary Fund and the marriage of Princess Elizabeth to Lieutenant Philip Mountbatten.
Kathryn Hopkins
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