The UK records two measures of inflation the CPI (Consumer Prices Index) and the RPI (Retail Prices Index). The RPI is the older measure, however the Bank of England’s target of 1-2% inflation is based on the CPI. The RPI is still used for wage negotiations and is a common part of commercial contracts.
The CPI has just risen to 3.2% more than 1% above the target range prompting the bank governor to publically explain why inflation is so high and what he is doing to reduce it.
In the same month the RPI shrunk to 0% for the first time in 1960. A worrying sign for those concerned about deflation.
How can the UK be experiencing inflation and deflation? In reality it can’t. The disparity between the two measures shows that economics is an inexact science and the models especially break down in unpredictable and volatile times.
Inflation measures never capture exactly what is going on in the real world. It is left to the judgement of those making the decisions to make up for what is lacking in their tools. Let’s hope they have what it takes.
I’m curious. Why is deflation considered such a bad thing?
Great Question! As a consumer I love paying less for the same product. However as from a business perspective as the price I charge for the same item goes down my margins get squeezed and I make less money. In a deflationary environment input costs into my business tend not to go down at the same rate. For example landlords are slow to drop rents and employees aren’t happy about taking a pay cut.
In actual fact several industries have been operating in a deflationary environment for decades. Think about clothes and shoes. The price we pay especially for basic clothes (think The Warehouse, and No1 Shoe Warehouse) have fallen steadily for years. Rather than Kiwis or other Westerners having to take a pay cut the jobs moved to China where wages are massively lower. Businesses closed down because they couldn’t compete or moved their manufacturing overseas.
Whilst the economy was healthy people who lost jobs could re-train and find jobs elsewhere for a similar wage. Whilst some people suffered in the short term this minority deflation (prices went up on average) was mostly benign.
If prices on average go down it means the majority of businesses are under price pressure and the economy won’t be able to soak up the labour from the job cuts. Job cuts then lead to consumers buying less so that businesses who are trading on lower margins also sell less and start loosing money and have to cut more jobs and so on.
Economists fear that the economy could get caught in a vicious circle of shrinking prices and greater economic deterioration that is difficult to reverse. Japan has been stuck in this economic quagmire for over 10 years.
Hope that answers it!