Deflation is coming to the UK. In fact, it is already here. Prices have fallen 3.8 per cent since last September, according to the official retail prices index. When the February figures are published, economists are certain the annual comparison will be negative for the first time in almost half a century.
While Britain is far from alone in watching the inflation figures tumble, it is unusual internationally in the number of contracts for savers, investors, pensioners and employees that are linked to the RPI – many of which were written at a time when falling prices were inconceivable “[Negative inflation] is striking because it hasn’t happened for such a long time,” says Jonathan Loynes of Capital Economics.
Peculiarities in the RPI may make the UK’s plight look worse than it is. The index’s treatment of housing costs – assuming all owner-occupiers have standard variable rate mortgages, which have plummeted as interest rates have come down – is not followed anywhere else and has been the main factor driving it down this year.
As such, the falls in prices already experienced can be viewed as “good” deflation, says Mr Loynes, since they will raise real incomes and help foster a recovery. The danger, though, is that the experience of a falling price index will change expectations about inflation, induce greater caution among consumers and foster further liquidation of assets to repay debts.
This is a significant risk, recognised by the Bank of England and causing worries at the US Federal Reserve and the European Central Bank. All have reiterated their ambition to maintain public expectations of low but positive inflation in recent weeks.
SAVERS
In a deflationary environment, there is little question that savers get a bad deal on interest rates. Mervyn King, Bank of England governor, said as much recently when he expressed “sympathy” with those who had done the right thing and not spent too much.
In January, the British Bankers’ Association reported a sharp outflow of deposits as savers sought higher interest rates elsewhere. Meanwhile, the UK’s building societies – which are dependent on retail deposits for funds – have expressed concerns about the impact that official rates near zero are having on fund flows. Data from the Bank of England show that interest rates on instant-access deposits are now comfortably below 1 per cent and likely to fall even further.
The prospect of outright deflation has even raised questions about whether savers could end up paying for the privilege of keeping cash on deposit. “Absolutely not,” says a spokesman for the Building Societies Association. “Most contracts say that interest is payable from the building society to the customer and not the other way around.”
What tends to happen, he says, is that savings rates linked to inflation promise to pay interest at some spread above the retail price index. If an account paid interest at 2 per cent above RPI and the index registered a 1 per cent decline, the rate paid would be 1 per cent. If RPI fell by 2 per cent or more, the account would pay zero interest.
Economists point out that deflation increases the purchasing power of savings. Some of what savers stand to lose in interest may be recouped by much lower prices for key staples such as food and energy.
Interest rates near zero seemed to have little effect on savers in Japan during the deflationary 1990s. Between September 1995 and January 2001, central bank rates were 0.5 per cent. The savings rate hovered between 10 and nearly 12 per cent of income until 2000. Savings slid after September 2001, when rates were cut to 0.1 per cent, but even then there was no net outflow.
PENSIONERS
Pensioners whose income provider is secure could be some of the big winners from deflation. Helen Ball, a partner at Sackers, the London-based pensions law specialists, says that at the very least they are unlikely to lose out.
Most trust deeds, which govern the award of discretionary increases, were written long before anyone contemplated the possibility of deflation. Even trustees of schemes where the deed implies that pension payments can fall would find it difficult to trim in line with RPI. “Morally, that is very difficult to do. People are expecting an increase to fixed incomes,” she says.
Most UK schemes rise in line with inflation, she says, albeit often up to a set limit. Some trust deeds make no reference to RPI but require annual minimum uplifts, say of 3 per cent, regardless of what inflation is doing.
UK rules require that deferred pensions – the benefits of those who leave their employer before they reach retirement age – have payments adjusted to reflect the effects of inflation. A short bout of deflation is unlikely to significantly dent their incomes.
The one group of retirees who could be harmed are those who have purchased annuities that allow for cuts in the event of deflation, according to Tom McPhail, head of pensions research at Hargreaves Lansdowne.
UK social security payments for retirees are index-linked and, even if inflation is zero, there is a small guaranteed annual uplift.
Most European state pension benefits and some private sector benefits are also index-linked. In France they are adjusted for the costs of living, while in Denmark disability pensions are adjusted in line with wages growth.
In the US, private sector pensions are never uprated for inflation and, in most cases, retirees see incomes fall in real terms as price increases erode purchasing power, according to Alicia Munnell, director of the Center for Retirement Research at Boston College. Deflation could help such pensioners, she says.
INVESTORS
Investors in almost every asset class bar government bonds are likely to be worse off in a deflationary environment, according to Graham Secker, equities strategist at Morgan Stanley. “Deflation is not good news for equities markets generally,” he says. “It is a signal that the economy is very, very weak and that sales and profits are going backwards.”
However, for companies that remain profitable, there will be pressure to maintain dividends, he says. While many companies have a dividend policy of maintaining a pay-out in real terms – ensuring that rises at least keep pace with inflation – they will be under pressure not to reverse themselves in a deflationary environment.
During some of the UK’s most torrid periods of inflation in the 1980s, corporate profits rose strongly because producers could put prices up. In a deflationary environment, the reverse pressures will be in force.
Investors in corporate bonds may find themselves somewhat better off. Interest payments are generally fixed – and even when floating are at a premium to some other interest rates, providing hard cash at a time when prices are falling. However, in a deflationary environment, the companies that issued these bonds are much more likely to default and investors may not get all their principal back.
There are real risks for investors in other asset classes, too. Commercial property, often seen as a risk halfway between equities and bonds, is rapidly falling in value. In the UK, virtually all gains since 2002 have been wiped out, and values are falling in continental Europe and in the US. Those who purchased it for the rental income are feeling the pinch, too; insolvent occupiers cannot pay rents.
The one group of investors certain to do well – at least initially – are those buying government bonds, Mr Secker notes. Governments rarely default and these bonds still carry regular income payments.
WORKERS
Pay is likely to be one of the most contentious issues debated during a bout of deflation.
Alistair Hatchett of Incomes Data Services, which tracks pay claims, says employers and workers are in uncharted territory. For decades, the rule of thumb was that salaries edged out inflation by 1.5 to 2 percentage points, allowing wages to grow in real terms. But in recent years, national average earnings have been subdued and lower than inflation, he says. A number of employers in the UK have already announced pay freezes, while others are discussing pay cuts as a jobs-saving measure.
The Engineering Employers’ Federation, whose members work largely in manufacturing, says that results of its wages survey for the quarter ending in January showed the average pay rise agreed over the period was 1.8 per cent, down from 2.7 per cent in the three months to December.
In January alone, the average wage rise was 1.6 per cent, down from 1.8 per cent last December and 2.9 per cent in November. “We had to double-check the numbers a few times because the scale of the movement was so unprecedented,” says a spokesman for the federation, noting that pay deals rarely move by more than 0.1 or 0.2 per cent over rolling three-month periods. The January survey, he adds, is particularly important because that is when most pay bargains are struck in the manufacturing sector.
Indeed, in light of the current outlook for inflation, the three-year wage deals that government struck with public sector workers last year, where annual pay rises range from 2.3 to 2.6 per cent, look generous.
Several UK unions struck deals last April at 5 per cent, while others settled in September and October 2008 with pay rises of over 4 per cent. Only one of the employers involved, British Midlands, is seeking to renegotiate. “The interesting thing is that there has been very little reneging on long-term deals,” Mr Hatchett said.
http://www.ft.com/cms/s/0/ac70b0fa-050c-11de-8166-000077b07658.html
JPTF 2009/02/28
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