From The Times
December 18, 2008
The party's over if deflation grips the economy
We explain why falling prices could wreak havoc with your finances
Inflation is tumbling and fears are growing that deflation, where prices actually start falling, may become a feature of the economy next year.
This week the Office for National Statistics reported that the consumer prices index (CPI), a key measure of inflation, fell to 4.1 per cent last month, down from a high of 5.2 per cent in September. Jonathan Loynes, chief European economist at Capital Economics, the consultancy, says: “November's CPI figures are another step along the path that is likely to lead to the first bout of deflation in the UK for almost half a century.”
While falling prices may sound great, deflation is actually considered bad for the economy. When prices fall, consumers defer purchases on the assumption that they will be able to buy the same goods cheaper at a later date. This damages demand which can undermine company profits, trigger unemployment and entrench a destructive economic cycle.
Here we explain what falling prices might also mean for your savings, investments, pension, house price and mortgage - and how to guard against the worst effects.
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Savings
To some extent, deflation is good news for savers because it increases the size of deposits relative to prices, making them more valuable in real terms. However, the downside is that the rates on savings accounts are likely to tumble if deflation takes hold because the Bank of England would reduce the base rate to 0 per cent or close to it. Savings rates are already falling fast. At the start of October, when the base rate was at 5 per cent, you could lock in to accounts paying an impressive 7 per cent. But now, with the base rate at 2 per cent, the most you can earn is about 5.5 per cent.
Returns in Japan, which suffered a decade of deflation, are close to non-existant. Simon Somerville, of Jupiter Asset Management, says: “The most you can earn from a Japanese bank account is about 0.4 per cent, but most pay nothing in interest. It is no wonder that many Japanese savers have abandoned banks and put their cash in safes or under the mattress.”
Savers in the UK may not end up quite so badly off, but only because our banks desperately need to bolster their finances. Some may continue to offer decent rates, as it is one of the easiest ways for them to raise money. So the pitiful state of the UK's banking system could yet offer a silver lining for savers.
Kevin Mountford, of the comparison website moneysupermarket.com, says that the best way for savers to guard against falling returns is to lock in to a long-term fixed-rate account. He says: “The best one-year fixed rate is from Anglo Irish Bank, at 5 per cent, but be quick as such rates could disappear soon. It is probably safe to lock up savings for up to two years, but any longer and there is a risk that the base rate - and savings rates - will start moving higher again. Nationwide is offering a two-year Isa bond paying 4 per cent.”
Pensions
Deflation could wreak havoc with retirement plans, especially if the problem persists for years. As prices fall, so will corporate profits and stock market investments. Given that many individuals and companies rely on shares to fund pension growth, many savers will have their retirement plans cast into doubt. Tumbling share prices have already wiped nearly a quarter off the average personal pension fund in the past year.
Even investors in final-salary plans, which guarantee a pension based on income, could hit the skids. As companies struggle to finance their pensions, the remaining final-salary schemes could close en masse. Even the Government, which backs the biggest final-salary scheme of all for public sector workers, may be forced to take drastic action, perhaps closing it to new entrants.
Tom McPhail, of Hargreaves Lansdown, the independent financial adviser, says that anyone approaching retirement should consider locking into an annuity sooner rather than later. He says: “As long as your pension fund has not been decimated by the recent stock market turmoil now might be a good time to buy a retirement income because annuity rates could well fall over the coming year or so. If you can afford to do so, deferring your state pension could also help. Provided that you are prepared to take the longevity and political risk - by which I mean that you don't think that you will die any time soon and you trust the Government to meet its promises - then you can boost retirement income by 10.4 per cent for every year you defer taking your pension.”
Those who are already retired could be among the few winners. Benefits, including the state pension, are linked to the retail prices index and can't be cut if inflation goes negative. The worst that can happen is that benefits remain unchanged. Many pensioners have fixed incomes, so inflation erodes their spending power. If prices drop, they will be able to buy more with their pensions.
House prices and mortgages
Homeowners are already experiencing deflation, with the average house price having fallen by almost 15 per cent over the past year, according to the Halifax.
Deflation in the wider economy would be a further blow because mortgage debt would increase in real terms, by becoming more expensive relative to prices. Fionnuala Earley, Nationwide's chief economist, explains: “Inflation tends to be good for borrowers, as it shrinks the real size of debt. In inflationary periods, wages also tend to rise, making it easier to meet mortgage payments. If there were deflation, debt would hang around longer and even grow in real terms, as wages would not be increasing and prices in the shops would be falling.”
Sadly, there is little that borrowers can do to mitigate the effects of deflation. Melanie Bien, of Savills Private Finance, the mortgage broker, says: “The first step is to keep up with your repayments. The mortgage should be your priority; everything else should be paid after that. You can also help by reducing your mortgage by overpaying. If you are lucky enough to have a tracker mortgage, you could overpay by the amount you are saving from lower interest rates.”
Most lenders will let you overpay by up to 10 per cent of your mortgage each year without penalty.
Ms Bien adds: “If you have an interest-only deal, it is worth considering switching to a repayment mortgage to ensure that the capital is paid off by the end of the mortgage term. This will mean significantly higher monthly payments, but it will be worth it in the long run. Speak to your lender about switching - it is very straightforward and can usually be arranged over the phone.”
Recent housing market history gives no indication whether residential property would be viewed as an attractive investment during a sustained period of deflation. Mortgages would continue to be available but the miserable experience of overextended borrowers could result in widespread aversion to debt, particularly among members of the younger generation.
At the same time, the lack of any meaningful returns from savings might persuade some people with spare cash to put it into property because bricks and mortar would be a tangible asset in an unfamiliar and insecure environment.
Additional reporting by David Budworth
Japan still licking its wounds
The most recent guide to what deflation might mean for UK investors is to look at what happened in Japan in the 1990s, writes Mark Atherton.
When Japan's property and stock market bubble burst with a vengeance in the early 1990s, the country experienced a prolonged period of deflation.
With consumers reluctant to spend because of falling prices, the economy stagnated, company profits fell and the stock market tumbled. The Nikkei index stood at nearly 39,000 at the start of the 1990s but now stands at a lowly 8,500, even though deflation has been eradicated for the time being.
John Hatherly, of Seven Investment Management, says: “What happened was that everyone started to draw in their horns and conserve their cash, rather than put it into assets that were falling in value. Investors deserted shares and property for safer havens.”
One of these safe havens was government bonds. Mick Gilligan, of Killik & Co, the stockbroker, says: “Investors reckoned, correctly, that the Japanese Government would not go bust and that government bonds were a safe bet, even though the interest they paid was small.”
Corporate bonds, on the other hand, tend not to fare so well in deflationary times because, with profits falling, there is less money to cover the bond interest payments and there is always the possibility of defaults on the payments or a collapse in the value of the bond itself if the company goes bust.
http://www.timesonline.co.uk/tol/money/consumer_affairs/article5366383.ece
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