Why the threat of deflation hasn't gone away

When my daughter announced this week that she is now prepared to wear jeans sometimes (for the past year, she has worn a party dress every day), I went straight to the internet to print out a discount voucher for Gap. For at least 12 months, the chain has offered a voucher of some kind giving 30% off, for anyone who can be bothered to look for it.

But, this time, there wasn't one. I visited all the usual websites - www.vouchercodes.co.uk, www.123vouchercodes.co.uk, www.moneysavingexpert.com and the like. Nothing.

So, for the first time in many months, I ended up paying full price (and not a particularly cheap full price at that) in a UK high street shop.

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Later that morning, the inflation figures for February were announced, showing that the Consumer Price Index (CPI) had risen 3.2%.

At the same time, the Retail Price Index, RPI, came in at 0%. Despite the fact that almost everyone expected February to be the month that proved the existence of deflation in the UK, there wasn't actually a falling price in sight.

So does this mean we can call an end to the deflation scare that has been stalking the globe for the last year or so? It does not. Instead, all the signs suggest that prices really will fall from here.

Think of it in terms of supply and demand. The demand story in the UK is miserable. Unemployment is rising fast.

And incomes are falling fast: according to the ONS, the average private sector employee is making £822 less than a year ago. Much of this is down to falling bonus payouts but the upshot is still that people have less to spend.

Anyway, who needs anything anymore? Surely anyone who fancied household goods stocked up during Britain's great Christmas sales binge? According to the Confederation of British Industry (CBI), 63% of retailers reported falling sales in March and 42% said they expect that trend to continue.

The story is much the same everywhere: the western consumers that are supposed to lead global growth have been terrified into keeping what cash they have left close to their chests. We haven't seen the natural consequences of this in the numbers quite yet for a few reasons.

First, there is the collapsing pound. This has pushed up the prices of all imported goods, from food to cameras. But it isn't a trend the inflationists should rely on: after the nasty run sterling has had, it could easily stick where it is or even surprise on the upside in 2009.

Then, there's last year's rise in utility prices, something that should soon fall out of the numbers.

Third, there is retailer resistance: Gap isn't alone at having a quick go at making us pay full price for its products high street retailer Next said this week that it wasn't cutting prices anymore, but I can't see this being a strategy likely to gain much traction. For starters, it is going to run into consumer resistance. We don't feel rich anymore and we expect retailers to take that into account when they set their prices. We want discounts.

But, more importantly, the massive overhang of global capacity means that their costs will surely fall they can cut prices without really slashing margins as suppliers battle it out for contracts.

There is, says Hugh Hendry of Eclectica Asset Management, "a tremendous pool of surplus capacity" in the exporting nations of Asia and Germany, one built to service a world that "simply doesn't exist" anymore. That surplus will "overhang the prices of tradable goods and services for years to come".

Finally, you have to remember that the most deflationary thing of all is a collapse of credit. And that, as surely everyone knows by now, is just what we have.

Quantitative easing may mean that there is more money knocking around the coffers of the world's banks but the fact that it is there doesn't necessarily mean that anything gets done with it in the short term.

Banks are still grappling with the problems of having insufficient capital in a highly risky environment so are more prone to holding on to reserves, while consumers and companies aren't quite as keen on borrowing as they once were. We are all desperately trying to pay back debt, not accumulate it. As long as that situation continues, the prices of the things we buy with debt are unlikely to rise.

Inflation will have its day. There is no way that the endless money-creating wheezes our governments are coming up with to stimulate our economies won't end up causing it at some point. But given the state of the global economy, that point is probably still some way off.

I bet there'll be new Gap vouchers knocking about any day now and pretty much every time I need one for the rest of 2009.

This article was first published in the Financial Times