Page last updated at 10:13 GMT, Tuesday, 21 April 2009 11:13 UK

What does deflation mean for you?

By Kevin Peachey
Personal finance reporter, BBC News

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This is the first time RPI has fallen below zero since 1960

One of the measures of UK inflation has fallen below zero for the first time since 1960, but what does this mean for you?

The Retail Prices Index (RPI) fell to -0.4% in March, dipping from zero in February and 0.1% in January. This is the measure of inflation that takes into account mortgage payments, which have fallen dramatically as interest rates have plunged.

The Consumer Prices Index (CPI), which excludes mortgage payments, shows that prices rose by 2.9% in the year to March, but down from 3.2% in February. The government's CPI target, its preferred measure of inflation, is 2%.

A falling RPI, despite many consumer prices still rising, could prove to be a mixed blessing for many consumers.

Who are the winners?

Although RPI has entered negative territory, there are some guarded winners. Some experts say that a short burst of deflation would be beneficial as it would act as a stimulus to the economy, with consumers' spending power increased.

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These consumers include retired people on the state pension, or those on benefits. Their income since the start of April has been based on the RPI figure last September - which was 5%.

So, if prices drop - or rose less than 5% - they would get more for their income from the state pension or benefits than they did a year earlier, especially given that essentials such as gas bills and food prices started to drop in March.

However, for many consumers without significant borrowings, there is not a lot of good news.

Many retired people rely on the interest from savings as an pension top-up.

MARCH INFLATION/DEFLATION

Consumer Prices Index: 2.9% (down from 3.2% in February)
Retail Prices Index: -0.4% (down from zero in February)

"Should inflation fall to a negative figure next year we would not be looking to reduce current benefit levels," a Department of Work and Pensions spokesman says.

The government has promised that the basic state pension will never rise by less than 2.5%.

However, some pensioners have index-linked pension annuities, so payments from their personal pensions will fall if there is a period of deflation. Those approaching retirement will also be concerned as annuity rates could fall.

Rail passengers' fares are set to benefit if the RPI falls to minus 1% in the future. The cost of standard regulated fares are linked to the RPI and are allowed to rise by 1% above RPI in July every year.

Who are the losers?

Those with mortgages have seen their repayments drop as interest rates have been cut, but essentially, there is no further for them to go.

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The RPI measure includes changes in mortgage rates

For those already in debt, a period of deflation will intensify the value of the debt, a so-called debt-deflation trap.

This could lead to a worst case-scenario with higher debts coming in tandem with lower asset prices and falling wages. This would create a cycle of job losses and weakening economic activity.

Savers would see the real value of their funds rise during months of deflation and fall during the months of inflation. Savers are suffering as interest rates remain low because they receive very small returns from their savings pot.

What about my wages?

You will be happy if you have already secured a wage rise this year, based on the high inflation figures of a few months ago (RPI was 5% and CPI 5.2% in September).

Such a wage increase will counter the rise in the price of some goods in the shops, and if there is deflation the real value of this extra cash will go up.

However, if RPI remains stubbornly below zero, the likelihood of managers agreeing to any pay increases in the future is slim. They are more likely to propose pay freezes, or even cuts if we go into some months of deflation.

What happens if prices fall?

Consumers would certainly celebrate in the short-term if there is a period of prices falling. But there are concerns that if prices keep falling, this could lead to a prolonged period of economic stagnation.

Flat or negative price moves pose a danger for the economy.

This might mean that consumers would delay making any significant purchases, because they assume the goods or services will be even cheaper in a few months time.

This could put the brakes on the economy, production could fall and more jobs could go.

Once deflation takes hold it can very difficult to shrug off. It is impossible to run negative interest rates - in normal circumstances by reducing interest rates to less than inflation you can, in effect, create negative rates. This means that the real economy can not be boosted as it normally would by low rates.

This is why the government and the Bank of England has looked to alternative measures - namely, the scheme to create new money known as quantitative easing.

It is also worth noting that excluding mortgage repayments, prices are still going up year-on-year.

Yes, I haven't noticed prices going down too much. What is going on?

UK inflation is calculated using a "typical" shopper's basket of 650 goods. From this, the Office for National Statistics (ONS) collects 120,000 prices each month to calculate inflation.

The ONS says that various items such as clothing and footwear, and computer games, rose in price in March compared with a year earlier. This helped keep the CPI at 2.9%.

In fact, stripping out food and fuel from the calculations shows that prices of other goods rose at a faster rate in March than in February.

CPI remains above the government's target of 2%.

The real mover in people's personal finances in recent months has been mortgage interest payments, which have pushed down the other inflation measure - RPI. People with tracker mortgages or variable rate home loans have seen their monthly repayments drop in recent months.



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