Osborne ‘don’t fear low inflation’ – but 0.5% could weaken economy says Warwick University expert

Transcript

Inflation in the UK is on a downward trend, and figures just released show rates fell to 0.5 percent in December – the lowest on record. Is this good news for the economy? World Finance speaks to Dr Dennis Novy, Associate Professor of Economics at the University of Warwick, to discuss what this could mean for consumers and the Bank of England.

World Finance: Dennis, 0.5 percent – it’s so low. What does such a low rate mean for the UK economy?
Dennis Novy: It’s good news for consumers in general. If prices are down and inflation is coming down, it means that real purchasing power has gone up, and their budgets are no longer as squeezed.

Now, the bad news is that if inflation keeps on falling even further, it might make life much harder for policy-makers, and for the Bank of England in particular.

The drop in inflation that has just come out is very steep this time around. And mainly that’s because of lower energy prices and oil prices having dropped quite a bit. But even if you strip out this recent drop in oil prices, core inflation has been on a downward trend for many months – actually a couple of years now.

If prices are down and inflation is coming down, it means that real purchasing power has gone up

The inflation rate might drop even further, which might put the UK economy closer to deflationary territory. That means the UK economy might weaken further, and it might be very difficult for policymakers to do something about it. In particular, the Bank of England might have to think about how it can re-inflate the economy. That will be a tough thing for them to do.

World Finance: So, 0.5 percent: this will mean a letter of explanation from Mark Carney to George Osborne. The first of this kind – because inflation is too low. What sort of pressure is the Bank of England under?
Dennis Novy: So the Bank of England needs to tell the public – not only George Osborne – how it will deal with this threat. If inflation continues to slip, it might have to actually think about unconventional measures.

Normally what the Bank of England would want to do in such a situation is cut interest rates. But interest rates have been very low for a long time now – for five or six years. They cannot be cut any further.

So what the Bank might have to do instead is think about more unconventional measures. Things like quantitative easing. This is something that we haven’t heard that much about recently, and we probably will hear much more about in the next few weeks and months.

World Finance: Do you think perhaps we’re a bit too infatuated with inflation as an economic measure?
Dennis Novy: Inflation is a key indicator of the economy. It matters to ordinary people; it matters how big their budgets are, and how far they go. So if inflation is very high their budgets are squeezed; if inflation is low they can buy more with their income.

But it also matters for policymakers. If inflation is very low, if it turns towards deflation, it becomes a big problem for central banks to deal with. Just look at Japan: Japan has had deflation for many years now, it’s been a major, major problem. Look at the eurozone – there’s deflation in the eurozone right now – in some eurozone countries such as Greece, there’s severe deflation. It makes for a huge problem to deal with the macroeconomy for central banks and governments. So I do not think that we pay too much attention to inflation; it’s important that we do.

Inflation is a key indicator of the economy. It matters to ordinary people; it matters how big their budgets are, and how far they go

World Finance: Well as you said, other countries and areas are going into deflation – such as Japan and the EU. So it’s not all doom and gloom, as our lower inflation rates will mean we can offer a more competitive edge?
Dennis Novy: Yes… in principle yes. But we cannot just look at the UK in isolation. In the eurozone inflation is also down. So you think about the relative change, it’s not clear that the UK competitive position has improved. You can’t just look at the inflation rate in one country in isolation; you have to look at it in other countries as well. And right now, certainly in Europe, inflation is on a downward trend pretty much everywhere.

World Finance: Is there a possibility we’ve entered a liquidity trap? And if so, how do we get out of it?
Dennis Novy: Yes! Inflation has been very low for a while, and interest rates in particular have been at rock bottom for a couple of years. So I think it’s clear by now, after so many years, that we are in a liquidity trap. Central banks find it incredibly difficult to get traction; interest rates cannot be cut any further. They have started quantitative easing: in the UK that has happened, in the US that has happened, people expect it to happen in the eurozone very soon.

I think there’s no doubt by now, even by detractors, that we have a problem. And it is a liquidity trap, and it might be quite difficult to get out of it.