Financial appraisals rely on assumptions about inflation – or deflation.
Financial appraisal in Registered social landlords is a tricky business, requiring the making of assumptions covering a period of 25 or more years. In the past few years assumptions made as late as 1997 have been shown to have been very inaccurate within a very short space of time. Rent control and the Supporting People changes have brought material changes to the income line, while pension costs and pay inflation have wrought similar havoc on the expenditure line.

However, it is economic changes that have had the most material effect and, in particular, movements in the retail prices index. Only a few years ago, the standard long-term inflation assumption was 4% and yet we are now looking at much lower inflation – 1.7% at the end of September.

A typical RSL appraisal stands or falls on the inflation assumption. Transfer RSLs' financial models have to show a payback after 30 years to get funding; 31 years isn't good enough, yet a reduction of 1% in the inflation assumption can add four or more years to the payback period. Mind you, it's not all bad news: falling inflation usually also means falling interest rates. This won't help in respect of fixed-rate debt but the variable rate cost should also fall.

RSLs need to find an inflation assumption for their appraisals, but what should it be?

A number of economic experts are now using the "d" word: deflation. Japan has suffered from deflation for some years and Germany seems to be heading the same way. Are we also at risk? Oxford Economic Forecasting's 25 October bulletin was headed Is Deflation a Real Risk for the UK? It concludes that the UK is less likely than Germany to suffer deflation for the following reasons:

  • the Bank of England is able to respond to deflation risks in a way that the German authorities cannot because they operate within economic monetary union
  • the government in the UK has much more fiscal room for manoeuvre than its German counterpart, which is having to cut spending to meet commitments under the growth and stability pact
  • the UK exchange rate can adjust much more easily to offset deflation risks than is possible for Germany
  • UK households have shown themselves much more responsive to changes in interest rates than those in Germany.

RSLs need to find an inflation assumption for their appraisals, but experts are now using the ‘d’ word: deflation

However, deflation should be covered in appraisal risk analysis and that should lead to an informed debate on Treasury strategy.

One of the risks that did get recognised in past financial appraisals was a rise in interest rates. This risk could be obviated by borrowing on fixed-rate terms, which most did. Fixing was the right decision since a rise might have been catastrophic.

However, while the close match between inflation and interest rates exists, but is not a certainty, and a link between rent and retail price index inflation continues (also not a certainty), variable rate or even index-linked borrowing would perhaps have been a lower risk than thought. The effect of taking fixed-rate debt was to forsake the protective link between inflation and interest rates.

Murphy's law operated, of course, as interest rates then plummeted and the avoidance of risk had also obviated the upside potential as well.