Deflation risks on the horizon: what it means for your savings and investments

With the energy price cap forecast to fall this year, inflation could also drop sharply - and we may start fearing deflation. But what would deflation mean for interest rates, and your savings, mortgage and investments?

White piggy bank on a domestic kitchen counter
(Image credit: Hispanolistic)

Households will be cheering that inflation has more than halved over the past year, and is set to fall further in 2024.

But as the price of goods and services tumbles, analysts are now starting to worry about the risk of deflation

Inflation rose by 4% in the 12 months to December. This was a surprise uptick from the 3.9% rate seen a month earlier. 

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Bar the latest data, inflation has generally been on a downward trajectory in recent months, and seems a world away from when inflation was in double digits a year ago. In October 2022, the consumer prices index (CPI) measure of inflation hit an eye-watering 11.1%.

And with the energy price cap forecast to drop sharply in April and again in July, this should push the UK inflation rate down even further.

However, the risk of deflation is now emerging. 

“Big falls in the Ofgem utility price cap in April and July could mean it’s not too long before we need to start worrying about the risk of deflation,” comments Ashley Webb, UK economist at Capital Economics.

We look at the latest predictions for inflation, whether we could see deflation this year, and what it could mean for interest rates and house prices - and your savings and investments.

What are the latest predictions for inflation - and could deflation become a reality?

Economists are expecting inflation to fall rapidly this year, and get below the Bank of England’s all-important 2% target in the coming months.

Analysts at Investec and Deutsche Bank predict that CPI will drop below 2% within four months, while ING Group expects the rate to plunge to 1.5% in May.

Capital Economics thinks inflation will hit 1.8% in April and then reach 0.9% by September. It says: “These falls are due to the rises in consumer prices in February, March and April of 2023 being very large relative to historical norms. Such favourable base effects mean that even if prices in those months this year rise by a bit more than historical norms, the inflation rate will still fall.”

However, the latest predictions for the energy price cap mean inflation could fall even further.

The energy analyst Cornwall Insight is predicting that the April cap will come down by 16% (the actual figure will be announced by Ofgem on 23 February), then drop by a further 8% in July.

Webb notes: “While April’s forecast is close to turning into an outcome, there is a lot of time for things to change before July. But if Cornwall Insight’s forecasts turn out to be right, CPI inflation may fall to 1.5% in April and to just 0.3% by September.”

He adds: “If the likelihood of inflation hovering just above 0.0% towards the end of this year grows, the Bank of England’s focus may shift from worrying about inflation being too persistent to fearing deflation.”

Vanessa Eve, investment manager at the wealth manager Quilter Cheviot, says she expects “a continued decrease in the rate of inflation in the UK this year”, adding that “you can’t rule out the risk of deflation completely”.

Laith Khalaf, head of investment analysis at the investment platform AJ Bell, agrees there is a chance of deflation this year, but calls it a “deep outlier, especially in light of tensions in the Middle East and a rising oil price”. He adds: “Though there’s a lot of 2024 still to go and anything is possible.”

What could deflation mean for interest rates and house prices?

Deflation will likely lead to lower interest rates as the BofE attempts to stimulate spending and borrowing.

“Deflation would be good news for mortgage borrowers, and by extension property prices, because it would give the Bank of England plenty of scope to cut interest rates,” comments Khalaf.

Interest rates are currently expected to be held at their current level of 5.25% at this Thursday’s Monetary Policy Committee (MPC) meeting, but then start to be cut from May or June. The markets are pricing in four base rate cuts this year.

Capital Economics predicts that interest rates may fall all the way to 3% in 2025. 

But, if deflation becomes a concern towards the end of 2024, the MPC could slash rates further.

What could deflation mean for my investments?

Deflation can create a challenging environment for investors. 

Eve explains: “Generally, deflation is associated with a slowing economy, which can lead to decreased corporate profits and lower stock prices. Investments in equities might suffer as consumer demand weakens and companies struggle to maintain profitability.”

Although, if the MPC cut interest rates and the deflation was short-lived, stock markets could rally - as long as the deflation was not “a sign of a permanent deterioration in economic prospects”, notes Khalaf.

In a deflationary environment, debt becomes more expensive in real terms, which can hurt companies with high levels of borrowing. So, investors could see lower returns across various asset classes.

On the other hand, bonds might perform better during a time of deflation, as the fixed income they provide becomes more valuable when prices are falling. “However, the overall economic slowdown associated with deflation can still pose risks to bond investments, particularly if it leads to increased default rates,” comments Eve.

How could deflation affect savings rates and annuity rates? 

If interest rates are cut, savings rates would also fall. 

“Savers would find the boon in rates they have enjoyed for the last year or so would dry up pretty quickly, as would those looking to buy annuities,” says Khalaf.

According to Eve, deflation can have a somewhat mixed impact for savers. 

She comments: “On one hand, the value of money saved increases as prices fall, meaning savers can buy more with the same amount of money. This increased purchasing power is a positive aspect of deflation for those with savings. 

"However, deflation often leads to lower interest rates. This means the returns on savings accounts and other low-risk, interest-bearing assets may decrease, making it more challenging to grow savings through these vehicles.”

Ruth Emery
Contributing editor

Ruth is passionate about helping people feel more confident about their finances. She was previously editor of Times Money Mentor, and prior to that was deputy Money editor at The Sunday Times. 

A multi-award winning journalist, Ruth started her career on a pensions magazine at the FT Group, and has also worked at Money Observer and Money Advice Service. 

Outside of work, she is a mum to two young children, a magistrate and an NHS volunteer.