Low inflation: something to fear or celebrate?

George Osborne has insisted that the British public should not fear yesterday's sharp fall in inflation, despite some economists' gloomy reaction to the figures.

"We should not confuse this welcome news with the threat of damaging deflation that we see in the Eurozone," he said.

He was responding to official figures announced yesterday which showed the rate of UK inflation had fallen to 0.5 per cent in December last year – its lowest rate in 14 years.

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The drop in inflation has been triggered by the falling price of oil, which has recently slid as low as $45 a barrel, as well as an ongoing price war between the big four supermarkets.

Osborne said that the UK could sustain "a few months of very low or even negative inflation" without any risk to the economy.

He said the UK's position was very different from that in the Eurozone, where "the debate has understandably turned to the dangers of deflation – the risk of a self-reinforcing spiral where economic activity falters, consumers defer purchases as prices fall and nominal debt burdens become ever harder to manage."

By contrast, Osborne said, the British economy was experiencing "rising real incomes, a recovery spreading to all parts of our economy, and family budgets that can stretch that little bit further".

He added: "Let's celebrate these effects of low inflation, not fear them."

Nevertheless, not all analysts agree with his upbeat assessment.

What is inflation?

Inflation is the rate at which the cost of goods and services goes up each year. Low inflation means that prices have stayed fairly steady, while higher inflation means that costs have increased rapidly.Inflation is calculated in a number of ways, but the most commonly cited scales are the Consumer Prices Index (CPI) and the Retail Prices Index (RPI).Both indices look at things people commonly spend money on, including beer, milk, bread and cinema tickets – and considers how their price has changed since the same time last year.

What is the difference between CPI and RPI?

RPI differs from CPI because it does not consider any costs associated with housing such as council tax and mortgage interest payments. CPI does take these factors into account. The way CPI is calculated also recognises that when prices rise, people may switch to buying cheaper products. RPI does not take this consideration into its calculation.

Why has inflation dropped?

Inflation dropped this week because of a combination of factors. First, since the middle of last year oil prices have been in a state of freefall, with Brent Crude, the global benchmark, falling from $115 per barrel last summer to less than $47 today. The second main reason is the battle between the big four supermarkets, whose ongoing price war to attract market share has significantly cut consumers' shopping bills.And third, December 2013's gas and electricity price rises are no longer feeding into the equation.

Why does the Chancellor say lower inflation is a good thing?

"Inflation is 0.5 per cent – lowest level in modern times," Osborne said on Tuesday morning in a tweet. "Welcome news with family budgets going further and economic recovery starting to be widely felt."

Rob Wood, an economist at German bank Berenberg, told The Guardian that the inflation report is "very good news indeed".He said: "Low inflation driven by cheaper petrol, food and import costs is unambiguously positive for the UK. It represents a big tax cut for consumers, who will be seeing real average earnings growth in excess of 1.5 per cent you within a couple of months."

The Institute of Directors agreed that the drop comes as "good news". But James Sproule, the institute's chief economist, warned that the Bank of England should raise interest rates to pre-emptively discourage reckless borrowing.

"Cheap money and high consumer confidence may provide a short term boost to the economy," he said, "but the longer the base rate remains at its extraordinary low level of 0.5%, the greater the risk of businesses and consumers assuming this is the new normal and adopting unsustainable plans that rely on these low rates continuing."

Why might low inflation be bad?

The BBC's economics editor Robert Peston notes that lower prices are "the equivalent of a chunky tax cut", and should therefore encourage consumers to spend more, providing "positive momentum for the economy".

However, he says, if inflation stays low for many months, people may defer their discretionary spending so as to profit from lower prices in the future, which could turn falling inflation into "deflation and slump".

TUC General Secretary Frances O'Grady also cautioned that the news may not be entirely positive, but rather served to underline the fragility of the global economy."While low inflation means we are finally seeing real wages start to rise, it will be many years before they are restored even to their pre-crisis levels," O'Grady said. "Seven years of falling real wages have undermined incomes and spending power; and the threat of slipping into deflation is very real."

Consequently, O'Grady warned, the Conservatives' plans to introduce further rounds of cuts expose the UK to unnecessary risk. "It's a very dangerous time for the Chancellor to be proposing a new round of austerity, which could plunge the economy back into recession," she said.