‘It’s bad news’ – why deflation in economy could mean ‘negotiating wage cuts’

Deflation discussed by Killik & Co's Tim Bennett

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THE UK’S consumer price inflation (CPI) exceeded the Bank of England’s target hitting 2.5 percent in June, and the central bank says it’s on course to rise above three percent before easing back. With the easing of lockdown, consumers were bound to go out more and spend freely on market goods so it’s not a surprise that companies are trying to make up for the profit lost and increasing their prices.

Although CPI has been increasing, some people are unsure about what will happen next. The rate of inflation soaring could be bad news for savers, but deflation could also have a negative impact.

Tim Bennet, Head of Education at Killik & Co, recently spoke about inflation and deflation, during a Kilik Explains episode on YouTube: “Now deflation you might think superficially, if you’re about to save money, is a great idea – but it isn’t. It does mean that prices fall, not just for single items but across the economy as a whole.

“It’s bad news because if consumers start to anticipate falling prices, they may stop spending, expecting to be able to buy things cheaper say a year from now.

“Deflation across the economy suggests that people should be negotiating wage cuts, not wage increases … psychologically if nothing else, that’s not something we’re used to.”

When discussing the impact on deflation for businesses, he said: “Without inflation, they are arguably disincentivized from taking risks and investing money.

“It’s to be hoped that central banks can keep the inflation ship steady. A small amount of positive inflation is a reasonable outcome, but they have to be on guard for either inflation spiralling out of control on the upside or tumbling back into deflation on the downside.”

Inflation in the UK is experienced when prices go up and the power of the pound goes down. It also reduces the value of debt, so borrowers keep borrowing and debtors keep paying their bills.

Consumers can also protect themselves from inflation to a certain extent.

Investing money could potentially help earnings grow faster than inflation, helping a person retain and grow their purchasing power, however it’s crucial to note that with investing, capital is at risk.

Unlike with inflation, debt becomes more expensive with deflation so it’s harder to protect oneself.

Businesses will stop taking them on as they try to repay debts they already owe that have increased.

Even though rising prices may seem like a bad thing, deflation is generally more harmful as it is associated with economic hardship which can spiral into recession and then depression.

Lower prices mean less income for producers which could potentially lead to unemployment and higher interest rates.

Eventually, higher unemployment will lead to less spending which can only negatively impact our economy.

Deflation is caused by two things: a decrease in demand or growth in supply.

If the demand for many different products declines, this leads to prices and services decreasing if the supply does not change.

The decrease in demand may be triggered by rising interest rates or adverse economic events, such as the global pandemic.

With demand for supplies decreasing, producers will have to lower prices due to increased competition.

The lower prices are what leads to wage cuts, or unemployment as the profit a business receives will ultimately decrease so they have to cut costs.

Decreasing prices may result in less production. Less production may lead to lower pay. Lower pay may result in a drop in demand. And a drop in demand may cause increasingly lower prices. And then the negative feedback loop continues. It’s a domino effect.

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