Outlook: Nanny costs still rising, but threat of deflation looms closer

Both the Treasury and the Bank of England assert that price deflation of the type that has ruled in Japan for some years now is not at all likely in Britain. On balance, I would go along with this view, but I'm less convinced by the day and it seems to me that the risk of outright deflation has grown quite considerably over the past year.

The official numbers show UK inflation continuing to bob along at close to the target rate of 2.5 per cent. Indeed, most forecasters expect it to rise to more than 3 per cent in coming months. That's mainly down to higher oil prices, but whatever the reason, it hardly indicates an economy on the verge of deflation.

Look beneath the surface, however, and price deflation in goods is already a reality both in Britain and the US (see chart). The eurozone has avoided the phenomenon so far, but that's largely down to the weak euro, which has kept the price of imports high.

The culprit is easily identified – intense price competition from the low-cost economies of the Far East and Eastern Europe. This is not something that will go away as soon as the world economy picks up. The pound is falling against most currencies, providing some relief for Britain's beleaguered manufacturing industries, but on any kind of a long-term view, price competition from overseas is destined to get more intense still, further depressing the price of goods.

Cheng Siwei is the vice-chairman of the Standing Committee of the National People's Congress of China. When I met him recently he had the following story to tell about China's development plans. China is growing at the rate of 8 to 10 per cent a year. By 2020, it plans to have quadrupled GDP to about 4,000bn dollars, or nearly as big as Japan's present GDP.

In itself this is a hugely ambitious target, but when you take account of the fact that 65 per cent of the population still eke out a peasant-like existence from the land, you begin to see the scale of the challenge. In most industrialised nations, the proportions are the other way around, with only about 30 per cent of the population still agrarian based. According to Mr Siwei, China aims to achieve this reversal within a 20 to 30-year time frame.

It took Britain 300 years for the same transformation to occur, and even the US took 100 years, with the cross over point being reached sometime in the 1920s. In short, China promises to be the biggest and most dramatic development story of the modern age.

As things stand, China's manufacturing revolution has to be largely export based, if only because there is insufficient domestic demand to support it. Average incomes are too small to allow for anything other than the bare necessities of life. Eventually purchasing power will improve sufficiently for economic growth to be driven primarily by domestic demand. But that point is a long way off, and in the meantime China is exporting deflation to the rest of the world.

There will be numerous economic crises before China arrives at its intended destination. The banking system, which is largely state owned and therefore incapable of properly assessing risk, strikes me as a particular source of instability. But the dynamics of the process are already unstoppable. More and more manufacturers are shifting their production to China and other low-cost areas of production, progressively forcing others to follow suit.

For Britain as a whole, it may not matter very much that the price of goods continues to deflate. The way things are going, we soon won't be producing many of them anyway. Everything is moving to China, Latvia or some place else with exceptionally low labour costs. Besides, falling prices only really become a problem if they mean that people stop spending, an eventuality which would poleaxe economic activity. Thankfully, there is not much evidence of this in either Britain or the US, for the time being at least.

Meanwhile, the price of services continues to rise at at a fair old clip, more than cancelling out the falling cost of goods. Inflation figures for January, published this week, tell you all you need to know. Compared witha year earlier, the price of clothing was down 3.2 per cent. Electrical appliances and do-it-yourself materials were down 2 per cent, cars and toys were down 3 and 4 per cent, while audio visual equipment was down an astonishing 13 per cent. The price of domestic services, on the other hand, were up 6 per cent, fees and subscriptions were up 9 per cent, household insurance was up 10 per cent, council taxes rose 8 per cent and the cost of foreign holidays was up 11 per cent. Again, this hardly looks like an economy on the verge of a vicious, downward deflationary spiral.

A couple of thoughts, though. One is that the export of jobs to low-cost economies is by no means confined to manufacturing. In growing numbers it applies to call centres, administration, IT outsourcing, software development and much else besides. India, and increasingly China too, has a vast pool of bright young, English-speaking graduates just dying to serve your every need. These days, they don't need to be an illegal immigrant to take your job. All that's required is a telephone line and and an internet connection.

Some service jobs can never go offshore – healthcare, education, construction, transport and large areas of professional services - but an awful lot can, and eventually we might see some of the same deflationary forces at work in manufacturing in the service sectors too. Deflation is not solely a Japanese phenomenon. It is also a fact of life in Singapore, Hong Kong, Taiwan, and now China. Meanwhile, it is threatening to become a reality in Germany too. Don't count on Britain remaining immune.

Go-Ahead outrage

Privatised rail companies have never had much shame, but Go-Ahead's 40 per cent increase in the dividend sets new standards for brazen behaviour. If punctuality and service levels were also rising, no one would bat an eyelid, but they are not. Passenger complaints have leapt and delays are getting worse on all three of Go-Ahead's south-eastern franchises, the worst offender being Thameslink, the aptly-named sardine line. In fact the only thing which is going up apart from the dividend is the pay of the directors, who seem to think they deserve much more just for working in such a wretched industry. The passengers may be about to storm head office, but the company is doing just splendidly according to Go-Ahead's new chairman. He, incidentally, is Sir Patrick Brown, the Whitehall mandarin who helped privatise the railways and the buses. Oh how the gravy train rolls on.

jeremy.warner@independent.co.uk