Low inflation good for consumers?

Low inflation is good for consumers and positive for economic growth The Times Nov 27

Andrew Sentance

Consumers are a big driver of economic growth, responsible for more than 60 per cent of GDP in the British economy. One of the key reasons for our sluggish economic recovery is that consumers have not been increasing their spending.
 

Since 2009, consumption expenditure has risen by only 1.2 per cent on average in real terms. That’s just one third of the average growth rate of UK consumer spending (3.6 per cent) in the 25 years from 1982 to 2007.

However, the good news is that the pressures on the consumer have been easing this year. Employment has been rising strongly and wage growth has started to recover. Most crucially, inflation has fallen below the 2 per cent target and at present stands at 1.3 per cent.
This is a big reduction from the 3.1 per cent average inflation in the six years of 2008-13 and the 5 per cent inflation spikes we saw in the autumns of 2008 and 2011.

As this cost-of-living squeeze has subsided, the growth of consumer spending has picked up, and with it the fortunes of the British economy.

This year will see the strongest growth of consumer spending in real terms since 2007, helping to take the UK to the top of the G7 growth league. Last week, we saw this confirmed by the strong growth of retail sales in October, which is not merely a flash in the pan.

So far this year, the volume of retail sales is more than 4 per cent up on last year, with prices dropping on the high street and boosting purchasing power.

Since the late 1980s, there have been only four previous years when retail sales volumes have grown

 by more than 4 per cent — 1997, 2001, 2002 and 2004. Low inflation contributed to strong consumer growth in all these years. In all four, CPI inflation was below 2 per cent, as it has been this year.

This should not be a big surprise to economists. In one of my first lessons in economics, I was introduced to the concept of the demand curve. As prices fall, consumers are prepared to buy more goods and services.

This is not rocket science. Consumers like lower prices. And they also like low inflation. Unfortunately, the present generation of economists has forgotten this basic fact of economic life.
Instead of welcoming lower prices and low inflation, they are warning us about the risk of deflation. A serious deflation is something to be avoided. When the value of everything is in decline in an economy, this is a serious problem. If consumers see the value of their assets dropping in value and their wages falling, they are likely to put off spending, which makes the resulting downturn even more severe.

However, that is not the problem that the UK economy faces at present. Wages are picking up, the London stock market is not far off its all-time high and the value of housing — the main asset owned by the British public — has been increasing, not falling. The value of the UK housing stock increased by nearly 5 per cent last, year according to the Office for National Statistics, and is up by nearly 20 per cent on 2008.

Deflation was a serious risk in 2008 and 2009. However, it is the dog that has not barked since the financial crisis, because central banks and governments have pumped money into their economies to avoid it.

Europe has become the latest focus of these deflation worries, and the latest figures show consumer prices falling in five continental countries — Bulgaria, Greece, Hungary, Poland and Spain. Yet in all of these, economic growth in the past year has been above the European average. Again, this is evidence that low inflation or gradually falling prices can help growth through its beneficial impact on consumer purchasing power.

So if low inflation should be good for economic growth and consumers, can it be sustained?
Two main factors have driven down British inflation since 2011-12. First, energy, food and commodity prices have fallen as global price pressures have eased. This reflects the subdued pattern of global growth after the initial rebound from the financial crisis in 2010.

Second, the pound has been gradually strengthening, holding down the prices of imported goods.
We cannot rely on either of these influences in the future, though. Global energy and commodity prices are highly volatile.

And the $35-a-barrel fall in the oil price we have seen in the past five months will not be repeated. If anything, there are now upside risks to energy and commodity prices as world economic growth is projected to pick up next year.

Meanwhile, the strength of the pound has been undermined by doveish statements from the monetary policy committee of the Bank of England in recent months. The longer the MPC delays raising interest rates, the more persistent this weakness of sterling is likely to become.

Other issues — such as the widening current account deficit and political uncertainty surrounding the 2015 general election — could also contribute to a weaker pound in the next six to twelve months.
So UK consumer spending and economic growth could subside if inflation picks up again. But the main message we should take away from our recent experience is that low inflation is good for consumers and a positive for economic growth. If price increases can be kept below the 2 per cent inflation target, that should be good news for the British economy.
Andrew Sentance is senior economic adviser at PwC and a former member of the monetary policy committee