Heed Teresa Hunter's advice and eliminate the threats posed by prolonged deflation

Published on Saturday 23 May 2009 14:12

THE cost of living continued to slide last month, with the retail prices index falling for only the second time since the 1960s. But while some will welcome tumbling prices, they will be less enthusiastic about the plunging wages and rising unemployment that comes with them.

The retail price index (RPI) fell to – 1.2% in April following March's 0.4% slide, according to the Office for National Statistics. The consumer price index (CPI) was also down to 2.3% from March's 2.9%.

The RPI index includes mortgage costs, so has dropped more sharply along with falling interest rates. The CPI index was driven lower by the slide in energy and food prices.

The Bank of England is gloomy about prospects for the economy and has predicted that CPI will remain zero or slightly above until for another three years. The RPI may well remain in negative figures for a while too. Governor Mervyn King believes recovery will be slow, subduing demand and therefore prices.

Any prospect of prolonged deflation would bring with it continually falling house, share and other asset prices, as well as lower wages. On Friday British Airways employees became the latest group to face the prospect of wage cuts and short-time working after the company announced record losses.

Yet commentators are divided about whether we really are facing the threat of a sustained period of deflation, or the recent data represents a temporary blip. Some believe inflation remains the bigger danger, following the massive devaluation in sterling and plans to pump even more money through the economy.

For this reason, consumers should hedge their bets, and protect against both. It could be that we have a short period of deflation, which would allow activity to continue in the high street, mopping up company stocks, and paving the way for a boost in production. This might reasonably be followed by a spurt in inflation.

The outlook is uncertain, and only a fool can pretend to know which way prices will move in the longer term. But it makes sense to take steps to avoid becoming a casualty of a prolonged period of 1930s style deflation even if you don't believe it is all that likely. We show you how.

Reduce debts

If prices continue plunging, taking the value of your home with them, at a time of wage cuts, the burden of your debts will grow. Debts remain the same size, but you may have less money to service them at a time when the asset they are purchasing is falling in value. Use any spare cash to pay off debts and stay ahead of the game.

Protect savings

It is vital to protect your savings from tax, so invest via an Individual Savings Account where it is still possible to earn more than 3%. Keep an eye on National Savings tax-free certificates, but the rates are currently too low to attract even higher rate taxpayers.

In times of deflation cash is king, because its buying power increases as prices fall.

It may also be an opportunity to swoop on bargain prices, particularly if the deflationary period proves to be short-lived.

Seek dividends

Shareholders have been hammered by a wave of falling dividends, with M&S cutting its dividend last week, hot on the heels of BT. But some firms, put at one in three, will continue to pay a rising dividend, even in these dark days.

You need to do your leg-work, but it will be worth sorting the risers from the cutters. Dividends matter. Sound, high-yielding shares tend to outperform in terms of share price rises as well.

Examine annuities

The return on annuities, depending on age, looks attractive, but the dilemma is whether to opt for an index-linked policy or stick with a flat one which pays a fixed income.

Index-linked annuities should be treated with care, because those bought from some companies, such as the Prudential and Standard Life, will follow prices down as well as up. In other words your income will fall along with RPI. Other firms, though, such as Norwich Union, L&G and AXA will not fall below zero.

Should inflation take off, however, index-linked annuities will protect you against rapidly rising prices.

That said they cost roughly a third more, which means they will hack a third off your income in early retirement, for the sake of preserving your standard of living later.

There are those who think you do better maximising your income in early retirement, when your health will allow you to enjoy it.