Despite Chancellor George Osborne’s claims, improvements in most people’s standards of living require sustained increases wages not price reductions argues James Meadway

Official figures for UK inflation, released today, show prices are increasing at the lowest rate on record – by just 0.5% on average over the year to December.

Elsewhere in Europe, inflation has actually gone into reverse. Across the eurozone as a whole, prices fell by 0.2% in the year to December 2014. For some individual euro members, the decline is even steeper, with Greece reporting a 2.3% decline in prices.

This can look like unmitigated good news. But, as I blogged yesterday, while falling prices can provide a short-term boost to people’s purchasing power, if deflation becomes entrenched it can have decidedly negative consequences. Consumers, expecting price decreases in the future, hold off on spending, dragging demand down; and if falling prices turn into falling incomes, the burden of debt steadily increases.

A short burst of general deflation may be worthwhile. A longer period of deflation, as happened in Europe in the early 1930s, or as Japan has witnessed recurrences of since the 1990s, can be disastrous – especially where debts are large.

For now, falling prices will have provided a long overdue boost to real incomes. After six years of decline, most people in Britain will have slightly more real purchasing power than they did this time last year.

One peculiarity in these figures, drawn out by NEF’s Real Britain Index (RBI), is that those lower down the income scale will be experiencing lower inflation than those at the top. We base RBI on the official CPI figures, but adjust for different household’s spending patterns, from poorest to richest. Higher inflation for the richest is a result of the prices of services more heavily consumed by them – education and restaurants, in particular – still rising sharply.

This is unusual considering recent patterns: the graph below shows poorest and richest RBI inflation rates every month from January 2007 to December 2014.

Since just after the 2010 general election, inflation has uniformly impacted the wealthy less than those on lower incomes. Today’s figures buck this trend for the first time – we estimate the poorest third have an inflation rate of 0.47%, slightly under CPI, while the richest third have a rate of 0.54%, slightly over. This, as with slowing price increases more generally, is primarily the result of the price of crude oil falling more than 50% since June last year. With oil at the centre of economic life, changes in its price feed quickly into the price of many other goods.

This shift in the impact of price increases does not undo the damage of high rates of inflation in the past. We estimate that, even with inflation now lower than average for the poorest, they will have experienced a 32% increase in the prices they pay since January 2007, compared to a 26% increase for the richest. Food prices, despite falling over the summer, are still up 26% since that time.

How likely is UK deflation?

Outright deflation in the UK is certainly possible, in the short term. ONS figures show the separate inflation rates for goods and for services, as below:

On this basis, the price of goods has already fallen into steep deflation, prices falling by 1% since December last year. This could, in theory, feed through into falling prices overall in the next few months. But the average price of services remains high: declining oil prices have taken longer to have an impact here.

The reason for this is fairly simple. Services, as you might expect, depend far more on the contribution of labour than do goods. To produce goods, you need (usually) machinery, raw materials, and labour. Transport costs, if we’re importing goods (and we do), are critical. To produce services, you may need some machinery (think computers) and you’ll use raw materials – potentially quite a few (think fast food). But you’ll need a lot of labour.

For prices to fall in services industries, you need to drive down labour costs; and with productivity gains generally harder to find in services, that will usually mean simply cutting wages and salaries. This can be done in real terms simply by holding down pay settlements, below the rate of inflation – as we’ve seen across the whole economy in recent years. But for service industry pay cuts to lead directly to deflation, you’d need to cut by more than the rate of inflation – or rapidly drive up productivity, which on current showing simply isn’t going to happen.

So UK deflation might be possible if oil prices continue to plummet. But there’s a limit to how low the price can fall – for what it’s worth, Goldman Sachs thinks $40 a barrel, and we’re not far off that now. Otherwise, it would take actual wage reductions in service industries, rather than the more typical phenomenon of shuffling of workers from higher- to lower-paid work, and very low money wage increases. This is only likely in the event of either sudden, unexpected technological innovation – or a major turn for the worse in the economy. The latter is, of course, more likely.

Put it another way. Declining oil prices could continue to feed into falling prices more generally. This will, in the short term, provide a boost to real standards of living. But for this boost to the standard of living to be sustained, deflation has to spread. That can only realistically happen with generally falling wages and salaries, necessary to bring down service prices. And that is exactly what will prevent a real improvement in living standards. We can’t, in other words, secure improvements in most people’s standards of living through price reductions. We’re not even likely to reverse the last six years’ of decline. What’s needed is sustained increases in the money wages paid.