How to survive if good times really do end with a bump

Prices of shoes and clothing have fallen by an average of 3.8 per over the past year - the biggest drop since 1949. Inflation without mortgage repayments averaged 2.1 per cent in 2000, the lowest since the retail price index began in 1976. Tesco is charging 0.4 per cent less for its goods than it did 12 months ago and expects to drive prices even lower in 2001. You can buy a mobile phone for a tenth of what one cost two years ago.

These figures show a pattern, according to most commentators. At the very least, the UK has fought off the old devil of high inflation. Some experts would go further, saying that global competition, technology and the internet have created a new economic environment which, if well-managed, gives little encouragement to high inflation.

But others warn that we are on the verge of deflation. 'The real underlying rate of inflation is probably negative already,' says David Potter, former chairman of City banker Guinness Mahon. 'We're in a period of sea change from an inflationary to a deflationary environment. It's not necessarily frightening, but people aren't used to it.'

If Potter is right, other statistics could look rather frightening. UK house prices recorded by the Halifax showed an average rise of 11.5 per cent in 1999, halving to 5.7 per cent in 2000 and forecast to slip to 4 per cent this year. After five years of growing by at least 10 per cent a year, the FTSE All Share index fell last year by 8 per cent.

The British memory of deflation is unhappy. Most recently, thousands of people's lives were turned upside down when property prices fell dramatically in the late Eighties and early Nineties.

Chris Lynas's job as fund manager of the top-performing S&W Fixed Interest Fund, managed by accountant Smith & Williamson, hinges on forecasting inflation and interest rates. He is not particularly concerned about deflation: 'It's probably far too early to be worrying too much about that. I don't think people need to do anything more now than those things which are common sense.' (See below)

Like many commentators, his main global concern is whether the US economy is slowing down too fast. Even if it is, he believes the UK economy is robust enough to avoid being infected.

The worst case scenario for this country, he believes, is 'asset price deflation', where house valuations, share prices and other major assets fall in value. Although difficult to handle, this is not as worrying as the overall deflation seen in the Thirties, where pay was cut as businesses had to reduce the prices of goods and services

People can take action now in case the worst happens. The first rule is to 'repay debt,' says Charles Levett-Scrivener of independent financial adviser Towry Law. 'Inflation helps people with large mortgages. It helps reduce the strain of that mortgage.' This is because while the size of the debt remains the same, the homebuyer's income probably rises each year - pay was up by about 4 per cent, on average, in 2000.

But the opposite happens during deflation: 'Mort gages become more difficult to repay,' says Levett-Scrivener.

This happened to hundreds of thousands of people during the Nineties: homeowners were unable to afford their repayments and had to sell their homes at a loss because their value had diminished.

S&W's Lynas takes a similar view to Levett-Scrivener's. Most people should not invest any spare cash, but use it to pay as much as they can off mortgages, credit cards and other debts, he says.

Potter, a former City banker, advises: 'Buy fixed- interest investments and keep a reasonable amount in cash. It is an uncertain time.'

Deflation could well lead to job losses and more people inevitably struggling to repay the mortgage, credit card bills and other debts.

Many homeowners would be very vulnerable if they lost their jobs since for the first nine months of unemployment social security payments are no longer given for properties bought or remortgaged after October 1995. For mortgages taken earlier, you have to pay your way for the first two months and then pay half the mortgage costs for the next four months before social Security picks up the whole bill.

With shares going through a difficult time, many people may prefer to review any holdings they have. 'Equities become less attractive in a period of deflation,' says Levett-Scrivener.

Lynas agrees: 'People with portfolios should build up their bond weightings a bit. Most people don't have enough in bonds.'

There is a strong argument for someone with an investment portfolio investing at least 10 per cent of it in fixed-interest stocks.

Of course, few would suggest that people dramatically change arrangements overnight. Salaries continue to rise as employers compete for staff, and the Bank of England's Monetary Policy Committee has held interest rates unchanged for 11 months.

But will next month's rate announcement, on 8 February, be a cut that suggests it is taking deflation more seriously? This is a story worth watching closely.

Financial fears still haunt 1930s survivors

People who survived the deflationary days of the
Thirties, with mass unemployment and
pre-welfare state hardship, are wary of
borrowing, says Chris Lynas, fund manager of the
S&W Fixed Interest Fund, who has spoken to
several such people.

'They tend to have very similar views on life,'
Lynas says. 'They don't like having a lot of debt.
And they tend to be quite cautious about where
they keep their assets: they have seen small
banks and building societies get into difficulties.'