Enjoy low inflation – but beware its side-effects

What are we to make of the UK’s ultra-low inflation rate? I think it should be viewed as good news – at least, on balance. We should remember that while low inflation feels nice, the main reason it’s happening isn’t necessarily beneficial to the UK economy as a whole. The recent collapse in oil prices puts a bit more money in our pockets, but it’s jeopardising our North Sea operations, one of the UK’s most important industries.

Above all, our reaction to low inflation, mustn’t dissolve into some kind of “deflation panic”. The zombie bankers, share-boosters and government debt junkies would then use it as an excuse for another round of mega-money-printing by the Bank of England, euphemistically known as quantitative easing. That would be seriously counter-productive – and must be avoided.

Last week we learnt that the UK’s consumer price index rose just 0.5pc in December, compared to the same month in 2013. That was sharply down from 1pc inflation in November and 1.9pc just six months before. Chancellor George Osborne greeted this CPI number as “welcome news” with “inflation now at its lowest level in modern times”. While we saw 0.5pc inflation back in May 2000, this latest inflation number is, indeed, the joint-lowest since the CPI index began in 1989.

It’s little surprise the Chancellor is crowing. Lower inflation, after all, is a bit like a consumer tax cut – the kind of feel-good move Osborne longs to deliver before the general election in May, but can barely afford to do. By boosting households’ disposable income, or eroding it less, lower inflation will almost definitely encourage higher spending, raising the headline growth rate higher than it otherwise would have been.

Low inflation may also means it’s less likely the Bank of England will begin finally to raise its base interest rate from the current historic low of 0.5pc, where it’s been since early 2009, when borrowing costs were slashed during the heat of the financial crisis. Many analysts, in light of this latest CPI number, now think the Bank won’t make its first rate move until mid-2016. That would please highly indebted firms and households, while bringing little succour to long-suffering savers and those living on fixed incomes.

Lower inflation is often associated with falling debts and prudent economic management. Not so in this case. Inflation fell in December almost entirely due to the recent oil price rout, with Brent crude tumbling from over $110 a barrel in June to under $50 today.

This is clear if you (ahem) drill-down into the inflation numbers. Overall energy prices were 5.8pc lower in December, compared to the same month the year before. Petrol was some 4.5pc cheaper. Household energy bills also contributed to the inflation drop – not because costs were cut, mind, but because the huge 6-7pc rises in gas and electricity bills of December 2013 weren’t repeated last month.

Despite the sharp falls in wholesale energy prices since the summer, in fact, the utility companies have passed on little in the way of savings to their retail customers. That’s started changing in recent days, not least because this eye-catching ultra-low inflation number is putting the utilities under heavy scrutiny. E.On – one of the “big 6” energy providers – moved quickly to cut its domestic gas tariff following the new CPI data and its competitors will surely follow.

The average petrol price across the UK has fallen £1.31 per litre in July to £1.11 last week. Even without a further drop in oil prices, we can expect competition to lower prices further, as the supermarkets and other petrol retailers pass on more of the wholesale price cut. With the utilities, similarly, bills are now likely – finally – to fall. All this suggests we’re in for at least a few months of abnormally low inflation, driven almost entirely by lower energy costs, as the impact of cheaper oil gradually ripples through to consumers, with the CPI perhaps even entering negative territory.

Were that to happen, it would be folly scream “deflation, deflation” and demand yet more British QE. These latest inflation numbers are almost entirely driven by the falling cost of oil and food – with the price of the latter being closely aligned to oil, given the vital importance of hydrocarbon-derived fertilizers and oil-powered transport and refrigeration to the cost of retail food. Exclude cheaper energy and food from the December CPI numbers and the “core” inflation rate actually rose from 1.2pc to 1.3pc – just below its 1.6pc long-term average.

Back in 2000, when the CPI was last at this level, core inflation was actually negative. We’re nowhere near that now. So we are in no way flirting with “a Japanese style deflation meltdown”, with consumers delaying their purchases, and investments stalling, because everyone thinks prices will be much lower in a few months’ time. That’s nonsense.

So there’s no justification, at all, for more QE, however much the bonus-chasing bankers and profligate spending ministers want it, knowing a bit more funny-money would send equities soaring to even more extreme valuations while allowing the Bank of England to buy up yet more government bonds.

What’s happening, in contrast, is that the price of oil has fallen way below its long-term fundamental value, for now, because the Opec exporters’ cartel, newly-emboldened and sick of the West conducting currency wars, has decided to do everything it can to lower the oil price, so squeezing and attempting to bankrupt upstart high-cost Western producers – in particular, the US shale industry.

One side effect is that UK petrol prices are falling, for now, and our cossetted utilities may soon be forced finally to reflect lower global energy prices in our household bills to at least some extent – because, as we all know, they’re quick enough to reflect global prices when they rise.

All that’s good, but it doesn’t mean that we’ve fixed our still moribund and too-big-to-fail banking sector, sufficiently reined-in government spending or ended the drip-feed reliance of this UK recovery on ever-rising household debt. New figures show that a pre-Christmas spending surge saw borrowing on credit cards and personal loans rise at the fastest pace since records began in 2007.

The UK household debt mountain is now 96pc of GDP and rising, placing us pretty near the top of the global personal debt league, with the US on 81pc and Germany on 57pc. While I’m glad the UK is now growing, it’s worth remembering that the engine of our recovery remains ever rising private and public debt.

Keep in mind, also, that while North Sea oil revenues are only 2pc of total government receipts, the industry directly employs around 170,000 people (a tenth of our industrial workforce) and another 250,000 indirectly. We’re talking about a sector that, in sum, generates around 4pc of GDP – and, at $50 oil, no new North Sea projects are profitable and, as such, investment there has stalled. So, enjoy low inflation, while it lasts, but remember where it came from – and the knock-on effects.

Consider, too, that the falling CPI numbers we’ve seen throughout the autumn as a result of the oil price falls since last summer mean that come September and October this year, base effects will start cranking inflation back up. So I think it’s entirely possible the Bank of England could still raise rates during 2015, especially if growth picks up as a result of cheaper oil. This low inflation number, as I said, is good news – but only “on balance”.

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