Negative inflation means a windfall for welfare recipients and some workers but will put further strain on State finances, writes JIM O'LEARY

YESTERDAY’S CONSUMER price index (CPI) report saw the annual headline inflation rate turn negative for the first time in almost half a century. The CPI in January was 0.1 per cent below its level of a year earlier and a rather more substantial 1.7 per cent below its level of the previous month. More than half the decline in January was due to falling mortgage interest rates, itself the result of the ECB’s big cut in official interest rates in December.

The most commonly cited other measure of consumer prices – the Harmonised Index (HICP), which
excludes the effect of mortgage rates and is the one used for comparative purposes across the EU – fell by 0.8 per cent in January to stand 1.1 per cent above its year earlier level.
There are strong seasonal effects present in the CPI in January.

The main reason is an obvious one – the post-Christmas sales. When corrected for these effects, the overall CPI fell by 1 per cent between December and January and the HICP by just 0.1 per
cent. These seasonally adjusted numbers give a more accurate picture of the trend in prices than the published figures. What they show is that, over the past several months, the trend has been firmly downwards. Since October, the overall CPI has dropped almost three percentage points on a seasonally adjusted basis (thanks largely to falling mortgage rates), while the HICP has fallen by just under 0.5 per cent on the same basis.

The latter figure suggests that the underlying annualised inflation rate was negative to the tune
of almost 2 per cent over the October-January period. A good way of interpreting this is that, if the pace of price reduction observed in this period is maintained until next October, the published year-on-year rate of HICP inflation will have fallen to minus 2 per cent by then. Given that mortgage interest rates have further to fall in the intervening period, this would mean a year-on-year
rate of CPI inflation of minus 3 per cent or more.

Actually, there are reasons to believe that the pace of price reduction will accelerate in the months ahead. For one thing, the full benefits of sterling weakness have yet to be passed on to consumers.
It should be said that this is not necessarily evidence of conspiracy amongst retailers and/or their suppliers. There are natural lags in the transmission of currency movements to high street prices
because of the running down of old stock, the unwinding of currency hedges and so on. The really
sharp falls in sterling occurred in December, too soon, given these lags, to fully impact on January
prices. That impact is likely to be more clearly seen in the next few months.

We are also likely to see prices soften a good deal further, particularly in the services sector, as
wages and salaries continue to adjust downwards in response to weaker labour market conditions.
For these reasons, it is possible (likely, even) that the average rate of CPI inflation for the year will be in the range minus 3 per cent to minus 4 per cent. Davy yesterday reduced its forecast for 2009 to minus 3.9 per cent.

It is interesting to compare the pace of deflation in Ireland over the recent period with that
recorded by the euro zone as a whole. One might have thought, given Ireland's relatively heavy
exposure to sterling and relatively steep descent into recession (as measured, for example, by the
exceptionally sharp increase in unemployment), that the drop in the inflation rate would have been
more pronounced here. Actually, it turns out that this is not the case: since last June, HICP
inflation has decelerated from 3.9 per cent to 1.1 per cent in Ireland and from 4 per cent to 1.1 per cent across the euro zone as a whole.

Some member states have experienced a considerably steeper disinflation. The Spanish inflation
rate fell from 5.1 per cent to 1.5 per cent between June and December; the Slovenian rate from 6.8 per cent to 1.8 per cent. On closer examination, it seems that the pace of deflation in Ireland
has tended to be relatively fast in respect of traded goods (for example, food and clothing), but
has been relatively slow in respect of some of the non-traded categories like education and catering. This is not a healthy pattern: it would be much more reassuring it the opposite were the case. The imperative that we improve our competitiveness means that we need to be reducing the prices of our non-traded goods and services relative to our competitors because these are an important part of the cost base for the internationally trading sectors of the economy.

Last October, the Department of Finance was forecasting an average inflation rate of 2.5 per
cent for this year. This was the forecast upon which the increases in social welfare payments – averaging a little over 3 per cent – announced in the 2009 Budget were predicated. The prospect of a negative inflation rate in the 3-4 per cent range means that those cash increases are now likely to
convert into real increases of upwards of 7 per cent, a welcome windfall for recipients but an additional source of budgetary stress for Government.

Similarly, an expectation that this year's inflation rate would be around 2.5 per cent underpinned
the wage increases negotiated by the social partners last September and this will now convert into windfall increases in purchasing power for those workers lucky enough to benefit from the deal. The other side of that particular coin is that it will make the gains in competitiveness
that the economy so urgently needs that bit more difficult to secure.