It’s inflation you should fear, not deflation

It's grim out there. Unemployment is rising, house prices are falling, and everything's generally awful.

So if you've got a relatively secure job, a variable rate home loan, and you drive regularly, you might be feeling a bit confused. You might even be feeling a bit guilty. Because the truth is, you're possibly feeling quite flush at the moment.

Of course, if you're a pensioner, or you just rent your house, your situation is probably quite different. You probably look at your bills every month and think that all this fear of deflation is nonsense.

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And you'd have a point...

Prices are falling - or are they?

This week we're going to be hearing an awful lot about deflation. On Tuesday, we'll learn that growth in the Retail Price Index (RPI) turned negative on an annual basis in February, after rising by 0.1% in January. In other words, prices are falling.

On the other hand, the Consumer Price Index (CPI) figures will also be out. They'll show that annual price growth is down, after rising at a 3% rate in January, but is still a good bit above the Bank of England's 2% target rate. In other words, prices are still rising, though not as fast as the month before.

What's it all mean? Well, it's just a very clear example of how inflation varies from person to person. Inflation isn't even the right word- we're talking about the cost of living here (inflation relates to the money supply, which we've written about several times here before- see: Inflation or deflation - which will it be?).

The main reason that RPI has fallen so sharply compared to CPI really comes down to one thing- housing costs, and interest costs specifically, which RPI includes while CPI doesn't. A recent report from the Institute for Fiscal Studies found that average interest costs on home loans had fallen by more than 30% over the year to January.

The large gap opening between RPI and CPI simply demonstrates exactly who the Government's 'stimulus' policies are aimed at- debtors.

As we pointed out above, if you are on a variable rate, your overall living costs have dropped sharply. But if you rent your home, or have a fixed rate loan, or own your house outright, then your inflation picture is substantially worse.

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So all this talk of deflation is actually something of a red herring for now. Deflation is exactly what the Government is trying to avoid. The whole point of 'quantitative easing' is to encourage lending and spending, and drive up inflation. But the sole reason that RPI has fallen into negative territory is down to the fact that interest rates have been slashed. This is why RPI isn't used as the main inflation gauge- because it rises and falls with changes in interest rates.

What does the future hold for prices?

So what does the future really hold for prices? I don't think the future is as deflationary as we might think. Many of the forces pushing prices down have fallen as far as they are going to go for now. Once those effects drop out of the annual comparisons, deflation could rapidly reverse.

House prices will keep falling, but interest costs can't really go much lower than they are now. Petrol prices have fallen sharply, but oil is now stalling at between $40 and $50 a barrel. Heating costs have room to fall, but it remains to be seen how far the utility companies will cut.

Meanwhile, food doesn't seem to be showing much sign of getting cheaper. Clothing and footwear prices are still falling, but the weak pound will make it a lot harder for retailers to make a profit on imported goods and maintain price cutting. On top of that, as life on the high street gets tougher, the weakest high street chains will be picked off. There won't be any government bail-outs for them. So retail capacity could easily drop off as rapidly as consumer demand, leaving fewer retailers with more pricing power, competing for a smaller chunk of consumer spending.

Meanwhile, items such as booze and cigarettes aren't going to drop in price for as long as they are huge sources of government revenue.

So despite the headlines this week, I wouldn't be planning for shop prices to fall sharply in the future. And I don't expect to see a long Japan-style lost decade in the UK either.

And what does this mean for investments?

But what does this mean for your investments? Well, I would avoid gilts, the bubble investment of the moment. I write about this in more detail in the current issue of MoneyWeek (subscribe to MoneyWeek magazine). For one thing, gilts will be demolished when inflation looks like making a return. But more to the point, the market is also heavily dependent on government policy, and as we all know, governments can change things on a whim, for political rather than economic reasons. I don't want to be relying on the government for my future returns. In other words, I'd avoid gilts for the same reason I'd avoid the banking sector.

And of course, I'd buy gold. For as long as deflation looks like being an issue, the world's governments will compete to have the weakest currency, which will drive gold higher as confidence in the financial system is rattled. And when inflation returns? Well, gold has a reputation for being a good store of value when inflation is rising. Find out more here about how to invest in gold.

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