Don't know what you've got til it's gone: Assessing the long-term costs of low inflation

Inflation in the UK fell to just 0.5 per cent in December, according the latest figures released today by the Office for National Statistics (ONS). The proximate causes of this drop are lower petrol prices – the result of the collapse of crude oil prices – and lower food prices, the result of a price war among Britain's supermarkets. Together, these falls subtracted 0.6 percentage points from inflation. But even without these falls, inflation would have been just 1.1 per cent, perilously close to the 1 per cent lower limit below which the governor of the Bank of England is required to write to the chancellor explaining why inflation is so low and what the Monetary Policy Committee intends to do to lift it back into line with the 2 per cent inflation target.

In fact, the easing of inflation pressures in the UK is a broad one. In its release, the ONS groups prices into 12 divisions. In 11 of these divisions inflation was lower in December 2014 than in December 2013. The only exception was restaurants and hotels, for which inflation was unchanged at 2.3 per cent. Food and energy prices have been the main factor in bringing inflation down, but 'core' inflation pressures have eased too. (1.1 per cent is the rate excluding only food and petrol prices, because the ONS highlights those as the causes of the fall in inflation in December. Excluding food, energy, alcoholic beverage and tobacco prices – which are the factors people often call 'core', although the ONS doesn't designate them as such, and alcohol and tobacco prices are not especially volatile – the latest inflation rate is 1.3 per cent.)

Even though inflation has moved further from the target that he sets, the chancellor has welcomed the drop in inflation because it boosts household living standards. Clearly, at this point in the political cycle and after several years of falling real wages, the chancellor is prepared to treat the inflation target as asymmetrical – that is, to worry less about low inflation than he would about high inflation.

In fact, this is a reasonable approach to take – up to a point. The fact that lower inflation is largely the result of lower global oil prices means that it is less worrisome than it would be if it was due to lower domestic inflation pressures. But it is not without its costs. For the government, lower inflation is likely to mean lower tax receipts, at a time when any offsetting savings from lower government spending will be limited because of benefit and pay freezes and the triple lock on state pension uprating. Over the medium term, it also increases the cost of the promise to increase the personal tax allowance to £12,500.

If the fall in inflation proves temporary, these costs are probably bearable. The risk is that lower inflation rates lead to a fall in inflation expectations and a further drop in the core (non-food and energy) inflation rate. If this also falls below 1 per cent, Britain could become locked in a low-inflation environment, with wage inflation remaining low despite falling unemployment. The risk of deflation would then become a serious one.

This is precisely what has happened in the eurozone, where core inflation was below 1 per cent throughout most of 2014 and the drop in energy prices caused overall inflation to end the year at minus 0.2 per cent. While policymakers might not have been able to predict the extent of the fall in global oil prices, the fact that core inflation had fallen to a level that created a deflation risk was the result of their failure to support demand growth in the region. The combination of tighter fiscal policies and a reluctance to ease monetary policy through quantitative easing caused the eurozone's economic recovery to peter out, and this led to lower inflation.

Although policymakers across the eurozone share the blame for this failure, the main problem is in Germany. It is German policymakers who are most insistent on eurozone countries cutting their budget deficits, despite accumulating evidence that this hits demand and growth when interest rates are persistently so low, at what economists call 'the zero bound'. It is German policymakers who insisted that the European Central Bank's inflation target should be for inflation below but close to 2 per cent, rather than symmetrical around 2 per cent as it is for the Bank of England (and who, in practice, seem happy when inflation is below but not close to 2 per cent). And it is German policymakers who will not accept that inflation across the eurozone of 'close to 2 per cent' would require inflation of around 3 per cent in Germany, because inflation is certain to be lower in other countries facing the biggest economic problems.

Even now, it is not certain that the ECB will act at the necessary scale when it next meets on 22 January. Briefings suggest that the ECB will announce a programme of quantitative easing, but that it will be nothing like the size of those undertaken in the US and UK, and structured in such a way as to fall far short of the monetary stimulus the eurozone needs.

Significantly, the ECB meeting comes just three days before the election in Greece, when Syriza, the radical-left coalition which argues for debt renegotiation and an end to austerity, could become the new government. Alongside all its other economic problems, Greece is a case study in the effect of deflation on an economy bearing massive debt. Despite several years of austerity policies (the economy has shrunk by more than a quarter since 2008 and unemployment is over 20 per cent) that have resulted in the government running a sizeable primary surplus, government debt is around 175 per cent of GDP and is not coming down. This is because Greece has been in deflation for the last two years, so that – despite a very modest economic recovery – nominal GDP is not increasing.

Greece's public debt is more than double the UK's and there has never been any serious risk that the UK would fall into the same straits with its public finances as Greece has done – not least because it is not stuck in a monetary union. But the Greek example shows how deflation can derail even the most aggressive attempt to reduce government debt. Because it would result in revenues falling well short of expectations, deflation in the UK would create problems for the next government if it was to insist on trying to eliminate the current deficit. That's why George Osborne, although he welcomed today's inflation data, should hope that it is soon back up close to its 2 per cent target rate.