Fasten your seatbelts - deflation is back

Deflation has arrived. The latest National Statistics Office figures reveal that the retail price index (RPI) fell by 0.4% last month for the first time since March 1960. Yet the consumer price index (CPI) the government's (and EU's) preferred measure of inflation is still rising at 2.9%. Confused? The difference arises largely because the RPI includes the cost of home loans. And these have been helpfully reduced by the many recent interest-rate cuts. So should a negative RPI worry anyone?

In short yes. But the impact will vary considerably. The falling mortgage costs implied by negative RPI will help households with tracker mortgages, for example. But if those households also include any private-sector workers they may suffer at their next pay review. Many private companies use the RPI as a guide for pay rises. Should it stay negative, some workers may face pay freezes, or even reductions as struggling firms look for ways to cut costs.

Many pensioners also stand to lose out from RPI deflation. Anyone, for example, who bought an annuity using funds from a money-purchase pension, "may be facing a drop in their income", warns Lauren Thompson in The Times. Level annuities (where a fixed amount is paid every year) won't be affected. But index-linked annuities, where the annual income usually increases with RPI inflation, are vulnerable to a drop. Norwich Union, Legal & General and AXA have said they don't plan to reduce income payments, but Prudential and Standard Life say savers will face cuts later in the year.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The good news even for them, however, is that the payout level on index-linked annuities is set once a year for a year. So "only those who bought an annuity in March of any year will face cuts because of the negative March RPI figures, which won't kick in for three months", say Sylvia Morris and James Salmon in the Daily Mail. The trouble is more annuity holders will be affected the longer RPI deflation lasts. "We expect RPI to stay in negative territory until August 2010. It will be falling by 3.5% by the autumn," warns Vicky Redwood of Capital Economics.

As for state pensions, they change every April, but in line with the previous September's RPI. So state pensions won't be directly affected by the latest drop. And even if the RPI is still negative in September, the government has pledged not to increase the state pension by less than 2.5% in 2010.

One clear group of winners from RPI deflation are those with student loans. The interest rate is reset each September based on the RPI from the previous March. This year that rate should drop by about 0.4% but keep the bubbly on ice until the government confirms it later in the year.