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Deflation raises fears for pay deals as falling interest rates and house prices, plus lower energy costs, push retail prices index below zero
Deflation will officially return to Britain today after an absence of nearly 50 years, when government data is expected to show that the retail prices index – the country's broadest measure of inflation – has turned negative.
After the indicator barely scraped over zero to 0.1% in January, another month of tumbling interest rates, collapsing house prices, and lower gas and electricity charges is expected by economists and City experts to have pushed February's figure to about -0.8%.
Though government sources say public-sector pay is unlikely to be cut, a sustained period of deflation would spell bad news for millions of public and private-sector workers whose pay deals are pegged to the inflation indicator. Students who took out loans before 1998 could benefit from lower interest payments, however.
Economist think the RPI could go as low as -4% this year and they fear it could stay below zero for up to a year before the combined stimulus the economy is receiving from the weak pound, the Bank of England's quantitative easing and a fiscal easing push it back up again.
Last night's bounce of nearly 7% in the Dow Jones industrial average is unlikely to feed through to inflation figures in the immediate term.
Howard Archer, chief UK and European economist at IHS Global Insight, said: "The inflation data for February should reflect the heightened pressure on retailers to price competitively, companies' diminishing pricing power, and sharply lower oil and commodity prices compared to 2008's peak levels.
"Most notably, retail price inflation is seen falling by 0.8% year on year in February, after rising by just 0.1% year on year in January, as it is further brought down by lower mortgage interest rates. Retail price inflation seems set to see some pretty sharp year-on-year falls over the coming months due to the mortgage effect."
The rate last dropped below zero in March 1960 when Harold Macmillan was prime minister and John F Kennedy was running for president of the United States. Inflation soon headed back up in the 1960s, but a sustained period of deflation would have serious consequences and could take Britain into the kind of lengthy stagnation seen by Japan in the 1990s and from which it is still suffering.
Although deflation brings falling prices, it is bad news for workers whose pay deals are gauged by RPI, and falling earnings reduce consumption, which adds to the downward economic spiral.
Figures from the Bank of England show that a third of firms have agreed pay freezes in recent months and some have cut pay. Yesterday, workers at Honda's car plant in Swindon were told they will have to take a 10% pay cut this year, following a similar announcement by Toyota to its workers in Derby this month.
In the public sector, pay has held up better, at about 2%. But John Philpott, chief economist at the Chartered Institute of Personnel and Development, said public-sector pay deals would inevitably head lower over the course of this year as the RPI fell further into negative territory.
Many workers in the public sector have their pay set by a review body and several *sectors, such as health, have agreed two- and three-year pay deals.
Pensioners will not suffer as much as many have feared. Each spring the state pension is raised in line with RPI from the previous September. This year pensioners will benefit from the fact that RPI hit a record high of 5% last September, driven mainly by surging oil prices, which peaked at nearly $150 a barrel in the summer.
Following the debacle of the 75p rise in the state pension in 2000, the government set a minimum 2.5% rise for pensioners for future years.
The government has also committed itself to not reducing any state benefits, should RPI go negative. Benefits this year will be raised by 5% or 6.3% on 6 April.
The Department for Innovation, Universities and Skills has said that interest rates on pre-1998 student loans have to track the RPI even if it turns negative. The government is reviewing the position for loans after that date. There is about £1bn of student debt outstanding from before 1998, so the government could face a cost of £5m as former students enjoy a big drop in their monthly repayments.
The government's preferred measure of inflation, the consumer price index, remains well above zero for now as it excludes mortgage payments and housing costs. But it is likely to fall below 3% today and below zero by the summer.
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