What inflation means for your money

09:43 25 March 2009

One of the measures of UK inflation has fallen to zero for the first time in 49 years, but what does this mean for you? This BBC guide should answer all of your pressing financial concerns.

The Retail Prices Index (RPI) fell to zero in February, from 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 3.2% in the year to February. This remains above the government's target of 2%.

The figures are significant as they show the shock inflicted by the credit crunch and the resulting recession.

A falling RPI, but a rising CPI, could prove to be a mixed blessing for many consumers.

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.

This time, hot rotisserie chicken, rose wine, and MP4 players were among the goods added to the basket.

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The ONS said that various items such as food, particularly vegetables, as well as toys and games, had risen in price. This is why the CPI has risen.

Prices have been rounded up as the effect of the recent VAT reduction from 17.5% to 15% has been reversed by some retailers, the ONS said.

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

Who are the winners?

If the RPI remains flat or goes into negative territory in the next few months, there are some guarded winners.

These include retired people on the state pension, or those on benefits. Their income from April will be based on the RPI figure last September - which was 5%.

So, if prices started to drop they would get more for their income from the state pension or benefits than they did a year earlier. However these groups tend to spend a greater proportion of their income on steadily more expensive food and fuel.

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"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 said.

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.

Graduates who took out student loans before 1998 will win if the trend in falling RPI continues. The interest on these loans tracks RPI.

About 1bn of debt is still outstanding on pre-1998 loans and the interest rate applied is based on the change in the RPI in the year to March. If this figure is negative, the government would have to pay out more than 5m to these ex-students.

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?

The fact that RPI is falling, but CPI is rising does create a mixed picture.

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However, for many consumers without significant borrowings, there is not a lot of good news. Regular purchases, such as food, are rising in price in the shops. Those who do not own their own home are not benefitting from the fall in mortgage costs.

That said, the real value of a mortgage-holder's debt would be eroded if there was a period of high inflation.

The opposite is, of course, true at the moment. So savers would see the real value of their funds rise during months of deflation and fall during the months of inflation.

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 at zero, or goes negative, 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.

"Job insecurity on the increase too, the combined effect of zero RPI inflation, rising CPI inflation, and recession is soon going to make it seem as though we are living through a depression," says John Philpott, chief economist at the Chartered Institute of Personnel and Development (CIPD).

What happens if prices start falling?

Consumers would certainly celebrate in the short-term if - as economists predict - there is a period of prices falling.

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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. Japan suffered this fate in the mid-1990s.

Source: BBC