'Joyflation’: beware the sting in the tail

Prices in the UK rose by 0.5%in December. That's remarkably low by post-war standards, and the lowest level since mid-2000.

By now, you will have read enough on the subject to be convinced that it is a good thing. That's because the main driver of it is plunging commodity prices, particularly oil. So as long as you don't work on a North Sea oil rig, or for a large oil services provider, it should make your life a little cheaper.

The cost of your commute and of your heating should be falling. The same goes for your food bill: last year's harvest was good, and the vicious discount wars consuming our supermarkets are marvellous for the majority of us.

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Look at it like this and you can see why some analysts are calling today's pricing environment 'joyflation'. Flat prices at a time of rising employment what's not to like? Quite a lot, actually.

The UK economy, as it is currently organised, assumes inflation. The state pension rises by the highest of inflation, average earnings or 2.5% every year. The commercial property sector offers upward-only rent reviews.

Fund managers make fortunes out of promising capital preservation on the basis that a bank account loses you money in real terms every day. Insurance companies pay out escalating annuities, where the payment rises automatically every year on the assumption that there is inflation.

And government finances only stay remotely sustainable by the use of fiscal drag: tax bands don't rise with inflation, so over time more and more of us get dragged into them. Tax revenues then rise without the state explicitly raising tax rates. This matters: government finances only work with the magic of inflation.

But the most important point about our economy and inflation is that we borrow because we expect inflation to rescue us from our debt. Remember buying your first house or flat? I bet your parents told you to 'stretch yourself' as much as you could on your mortgage. Because, barring disaster, inflation would make the payments look like peanuts and the house look like a treasure chest within a decade or two.

It isn't just about houses. UK productivity is falling, for reasons that no one quite understands, so in order to produce acceptable growth rates, we rely on financial leverage.

We have a high exposure to the financial services sector, and still growing levels of consumer and public sector debt. As Pelham Smithers, founder of the research firm of the same name, puts it, if you look only at the money, we are less a country than a vast hedge fund.

That is sort of fine when interest rates are falling, and particularly when they are lower than inflation, as has been the case for some time. If the real value of your debt is being eroded at only a slightly lower rate or even a higher rate than you are paying in interest, you have every incentive to borrow. After all, the money is basically free.

So falling rates give us higher borrowing. Note the 13% rise in new car financing volumes in the UK in the year to last November. All this gives us growth, employment and the capacity for yet more borrowing which feels nice.

However, it is also a virtuous spiral that can easily be destroyed by falling prices. Interest rates can't really fall below zero (although the Swiss National Bank is currently testing this idea), so as soon as prices go negative and we get deflation, then inflation-adjusted (or real) interest rates start to rise.

That changes the equation. Usually interest rates rise because prices are rising, but in this case, they would effectively be rising because prices are falling. The result is that falling interest rates and debt-eroding inflation are replaced by rising interest rates and debt-enhancing deflation. Are those the kind of circumstances under which you might 'stretch yourself?' I suspect not.

Instead, borrowers living in deflation start to feel over-stretched and set to work to pull themselves back from the debt brink. And so our happy spiral of borrowing and growth turns, in the short term at least, into a misery vortex of deleveraging and recession.

I'm not convinced that this is about to happen in the UK. The consumer price index (CPI) might be just 0.5%, but theretail price index (RPI which we all used to think of as the standard inflation measure) is still coming in at 1.6%. 'Core' inflation, which strips out volatile things such as food and energy, is 1.3%. Service sector inflation, vital because so much of our economy is service based, is steady at around 1.4%

But it is worth keeping an eye on. For now, low commodity inflation looks like it represents a nice cost reduction, but it doesn't take much for good deflation to turn bad in an overleveraged economy. That's something the world's central bankers know full well, and it brings us to the second major risk surrounding the threat of deflation.

Ronald Reagan used to say that the most terrifying words in the English language are "I'm from the government and I'm here to help". If he were thinking of clever soundbites today he would change that to "I'm from the central bank and I'm here to help".

We've already lived through many years of extreme monetary policy in the UK, the US, Japan and China, and its bonkers effects on investment incentives and markets.

Let's not forget, for example, why the oil price has been falling so fast. Easy money pushed up demand in China, but then facilitated the rapid rise of supply in the US. In a normal world, Chinese demand would probably have risen, just not so much. And US supply might have risen too, just not so much.

The oil price would have gone up a little, then down a little. Instead, super-low interest rates and quantitative easing meant it went to extremes in both directions.

The rising threat of deflation suggests calls for more extreme monetary policy (the ECB could well oblige thisweek), and a series of shocking market movements. Best get used to it.

This article was first published in the Financial Times.