Tiziana Simonetti (ABC Economics) on the UK economic outlook and the consequences of deflation. First of all we want to underline the negative consequences generally produced by deflation: delayed consumption that means that the lower inflation could, unless it is counteracted by a rise in real incomes, lead to delayed consumption and weaker demand. This could cause prices to fall further and lead to persistently weak demand. Another risk we should take into account is called debt deflation i.e. if price deflation is accompanied by low or negative nominal income growth and relatively high nominal interest rates; households, companies and the government may find it progressively harder to repay debt. As a direct consequence they may be forced to cut back on spending in order to meet debt repayments and as further in reducing demand and prices. The resulting arrears and defaults also may lead to stress the financial institutions.
HOW GENERALLY ECONOMY RESPONDS / The appropriate response to avoid long lasting deflation would be to lower the nominal interest rates in order to offset rising real interest rates and counteract falling nominal incomes. The cuts in interest rates during the recession are been necessary to limit the extent of the downturn.
REAL ECONOMY / Recently, real incomes in the United Kingdom have been growing at their strongest rate since 2008. There is little evidence of consumers delaying purchases. Most measures of inflation expectations are broadly consistent with the 2% target set from Monetary Policy Commitee of Bank of England. There are also few signs of either debt deflation or increases in financial stress due to debt affordability concerns. The ratio of household debt to income has continued to fall from a relatively high level. Nominal interest rates faced by households for new borrowing remain low. And indicators of household debt affordability remain benign. Moreover, the MPC has the tools to bring inflation back to the target, and stands ready to use such measures as appropriate.
For forecasts please refer to the infographics Stefano Fugazzi, the ABC Economics founder, published on Election Day.