Following the predictions made by the Governor of the Bank of England in February this year, negative inflation, (deflation), has now officially arrived. This is the first time the UK has experienced deflation since 1960. Whilst this current period of deflation is largely a result of falling oil and food prices, it could result in falling prices generally.
A natural assumption would be that since inflation makes us feel poorer, a period of deflation will make us feel wealthier and therefore the economy will benefit. Regrettably, the truth is far less rosy. Falling prices lead to an expectation that prices will continue to fall. This causes both consumers and businesses to delay discretionary purchases since a delay will make the goods cheaper.
An example of this would be a decision to delay buying a £20,000 car for 12 months due to the expectation that the price might be only £19,000 in a 12 months’ time. However, when that year has passed, there will be an inclination to further postpone the purchase with the expectation that the price will fall more. This is how the deflationary cycle can begin.
There are a few knock on effects which make deflation so dangerous to businesses:
- The tendency to delay discretionary purchases will result in a drop in turnover and cause businesses to be left with large stocks of unsold inventory.
- This effect is then passed up the supply chain from retailers to their suppliers and then to their respective suppliers. So whilst you will be less inclined to purchase from your suppliers the same can be said for your customers. Consequently, the effect spreads through the whole economy.
- Unsold stocks held by a business will reduce in value meaning that the business can make a loss simply by holding stock as the market price falls. High levels of unsold stock can result in very significant losses once you factor in the likely additional effect of stock obsolescence.
- The anticipation of these effects as well as falling turnover can make businesses more cautious, hold smaller amounts of stock, delay capital investment and even make redundancies to reduce overheads.
- Media reports of redundancies causes consumers to tighten the purse strings exacerbating the effect by bringing on a period of recession.
- Debt will grow in real terms. Therefore after a year of 1% inflation a mortgage with a balance of £100,000 will feel in real terms like a mortgage balance of £101,000. This effect can leave consumers with a reduced disposable income and a greater inclination to save rather than spend.
The net effect of these factors is that a short period of deflation can spiral into a much longer deflationary cycle as shown by Japan since the early 1990’s. Therefore Mark Carney’s prediction that prices are likely to rebound at the end of this year may prove overly optimistic.
So what should businesses do to minimise the impact on profitability? The simple answer is that there is no one-size fits all answer but taking a serious look at your stock levels is a good starting point. If you have any concerns that deflation might cause your business difficulty, phone Lynn Gibson on 01932 336149 for a free 1 hour business review.
