Rate cuts should continue despite falling inflation

Inflation fell to 4.1% in November, a smaller fall than anticipated, but still low enough to fuel further interest rate cuts, according to Capital Economics.

Britain’s Consumer Price index (CPI) fell 40 basis points from 4.5% in October although consensus forecast was to 3.9%.

The Office for National Statistics says the largest downward pressure was from transport costs where prices fell but this was offset by upward pressure from food and non-alcoholic beverages. The average price of petrol fell by 9.3% per litre between October and November this year, to stand at 95.2p, compared with a rise of 3.5p last year. However fruit and vegetables rose by more than a year ago and airfare inflation also rose.

Jonathan Loynes, the chief European economist at Capital Economics, says: “These factors will not prevent inflation falling much further over the coming months. Recent drops in agricultural commodity prices suggest that food prices will soon fall sharply, while petrol prices will continue to fall in response to the drop in oil prices. Meanwhile, recent sharp falls in wholesale energy prices suggest that household gas and electricity prices should soon start to ease.”

He added that while Mervyn King stopped short of predicting deflation in his latest letter to the Chancellor explaining why inflation is still more than 1% above its target, he did concede that it could fall below 1%.

“As such, it seems clear that the inflation outlook presents no obstacle to further cuts in interest rates.”

James Dowey, an economist at Neptune, also says further interest rate cuts are on the cards and the group’s house view is that the base rate could fall below 1%.

He adds there are four main factors contributing towards falling inflation such as huge household debt, businesses experiencing a drying up of credit, utility bills coming down and unemployment rising.

“We do not see prices rising at all but the swing down from high inflation to deflation could be pretty nasty. It would increase the real value of people’s debt and incentivise the consumer to save and not spend. If this happens too quickly it could cause a dislocation in the economy.”

Dowey says the Bank of England needs to use more unusual parts of its toolkit, such as printing money, as well as cutting interest rates to curb the threat of deflation. It will also need to lend even more to the banking system, in return for poor collateral, to get liquidity into the system.

“Deflation is avoidable if the Bank of England throws enough at it. If we fall into the deflationary trap it will be very bad for British stockmarkets. A mere recession is, in a way, desirable as opposed to the deflation/depression road. The market does not know what is going to happen yet so is pricing in a combination of both so if policy response is strong enough to avoid a depression we could see strength in British equities.”

Meanwhile, the Price http://www.bls.gov/news.release/cpi.nr0.htm ” target=”_blank”>consumer price index for All Urban Consumers (CPI-U) in America decreased by 1.7 percentage points in November, reports the Bureau of Labor Statistics.

This is the second consecutive record decrease and was attributed to falling energy prices, which if excluded the index is virtually unchanged.

“The energy index fell 17% in November. The decrease was about twice the October decline and energy prices are now 32.4% below the July peak earlier this year,” says the report.