Consumer price inflation will probably fall to around minus one per cent by the end of this year, and inflation as measured by the retail price index could fall to 3 per cent by the year’s end, predicted a new report from Deloitte out yesterday. And that is good news, of course it is. If things get cheaper, we are better off. But, there is a danger that deflation could become more serious in 2010. That is why the government needs to act, to ensure this doesn’t happen.

The report was penned by Roger Bootle, head honcho at Capital Economics and economics adviser to Deloitte. He argued that initially deflation: “… will be driven by sharp falls in food and energy prices, though the Pre-Budget Report’s cut in VAT will also play some part. Falling house prices and interest rates will push RPI inflation (which includes housing costs) down particularly sharply.”

And that is good. “… a brief, narrowly-focused, bout of deflation should do little damage to the economy. Indeed, by boosting households’ real spending power and perhaps allowing firms to widen their profit margins, it may even help to lay the groundwork for a recovery,” argued the report.

But, if deflation settles, and falling demand promotes further price cuts, then that could be disastrous. The key, really, lies with average wages. If wages continue to rise, while prices fall, then that is good. But, if wages fall, then a nasty downward spiral can develop. And bear this in mind: if you think the UK is burdened by debts that are too high, imagine how bad these debts would look if prices start falling. Debt deflation really will spell bad news.

The Deloitte report said: “… longer period of deflation would have much more damaging consequences. The boost to households’ real income would soon fade as wages and benefits fell. Meanwhile, households would suffer from rising real debts and falling asset prices.

“Of course,” continued the report, “policymakers are taking aggressive action to avoid this scenario. Official interest rates are set to fall quickly to zero (or very close) and are likely to be accompanied by a range of unconventional measures to get longer-term interest rates down and increase the amount of money in the banking system and economy.

“There is hope that these actions will help to prevent a very serious, Japanese-style, bout of deflation. But they won’t be costless. A further deterioration in the already dreadful state of the public finances will increase the need for a major fiscal consolidation over the medium-to long-term and could increase the tax burden on future generations.

“What’s more, they may not prevent consumer price deflation from becoming a more familiar feature of the economic landscape over the coming years. A re-assessment of the macro-economic policy framework is likely to put greater emphasis on a broader range of price pressures and, in particular, asset prices. This could mean that short periods of negative CPI inflation become more common.

“One way or another, then, households, companies and the policymakers all need to start thinking more seriously about how to live with deflation.”

An important point here, often overlooked, is that a number of people are arguing that the cuts in interest rates are unfair on savers. But remember, deflation rewards savers anyway, deflation punishes borrowers. So if deflation does return, saving will come back into fashion even if rates fall to zero. The key lies with real interest rates – that’s the difference between the nominal interest rate and inflation. In recent weeks, a number of people have overlooked this point.

Mind you, not all agree with Mr Bootle. This morning, a report from JPMorgan put the opposite case. ”In the short-term,” said the report, the global slowdown and the lack of credit is leading to a general deflation of the price of real assets. This trend will continue and even accelerate in the next few months as global demand remains subdued. A further slowdown will leave China with growing inventories and the need to create an aimed 9 million new jobs next year . This is crucial to avoid social unrest, so the authorities will likely try to force a controlled depreciation of the renminbi in order to benefit exports, while at the same time, they keep providing incentives for domestic demand through further fiscal stimulus. This forced depreciation of the renminbi would exacerbate the already strong global deflation pressures in the short-term.

“However, in the longer term the real problem will likely be inflation. Nominal interest rates have gone down globally, in the US alone by more than 4 per cent in a year and despite taking into account the abnormal large spread between the Fed fund rate and the 3 month LIBOR rate (the latter stands at 113 bp, which is extremely low on historical standards).

“In the US, according to the Congressional Budget Office the budget deficit for this fiscal year will hit 1.2 trillion USD (8% of the estimated 09 US GDP) and that without taking into account the initial 775bn USD Obama fiscal plan which can go beyond another trillion before it gets approved by Congress.

“All this liquidity will probably mean large inflation numbers in the medium term, which is also the less painful way to deleverage the system. How large that inflation will be will depend not only on the quantity of the liquidity injected in the system through the different plans but also on the “multiplier effect”– banks will have to start lending that extra liquidity or these measures will not fully work. Paradoxically, large inflation numbers in the future will be a clear sign that all the measures taken have worked and inflation will then become the next problem to solve.”