Sunday, May 16, 2004
Warning signs point to higher inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

One useful way of assessing how “hot” a topic may be, is by counting the number of pieces about it in newspapers. This used to be a laborious process but, thanks to the wonders of modern computer databases, it can now be done in a few clicks.

Thus, deflation — a fall in the general price level — was clearly a hot topic a couple of years ago, with 897 stories about it in UK newspapers in 2002. It built up even further last year, with 1,194 stories and articles, according to one electronic database I consulted.

That seems to have been the peak. We are now well into May and the number of pieces about deflation has slowed to a trickle — just 205 so far and most earlier in the year.

Deflation never happened. Some prices fell, for cars, electronic gizmos, clothing and footwear and a range of other goods. But the general price level kept rising, because of inflation in the private and public-service sectors.

The Bank of England, which always insisted that the probability of a deflationary spell in Britain was extremely low, was right. So were those of us who stood out against the deflationary view, even when it was the height of economic fashion.

Now that deflation fears have been banished (including by America’s Federal Reserve, which saw it as a greater danger than the Bank did), you might think we can relax. Actually no, for no sooner have deflation fears dissipated than inflation worries are gaining strength.

This is not a sudden shift. Concerns about rising oil and commodity prices began to surface a couple of months ago. This column on February 29 was headed “Inflation beast starts to stir”.

Since then some commodity prices have dropped back because of profit-taking and action by the Chinese authorities to slow their economy. Even so, the Reuters commodity price index is up some 30% on a year ago. The price of steel scrap — in the past a good forward indicator of inflation — is up by between 69% and 126% on last summer.

And one commodity that has not succumbed to profit-taking is oil. A few months ago it was reasonable to expect oil prices to settle at $25 a barrel, the middle of the $22 to $28 target range set by Opec (the Organisation of Petroleum Exporting Countries). Then more than $30 a barrel became the norm. Now analysts are saying that for the foreseeable future oil will stay at $40 a barrel or higher (the price for West Texas intermediate crude, our own North Sea Brent trading somewhat lower).

China’s impact is again evident. As the Bank of England pointed out last week, China’s oil demand has risen by 77% in the past decade, its share of world demand up by a half.

Until this very recent shift to new, higher oil-price levels, it was hard to detect much of an effect on Britain.

But the move to $40 oil has happened in combination with a drop in the value of the pound from $1.90 to $1.75. Oil at $40 means petrol prices of significantly more than 80p a litre. It also means higher prices for business users.

In the past, higher oil prices were a huge boon for the Exchequer because of Britain’s role as an oil producer. Those days are gone. Oil production has been declining this year and North Sea revenues, at 0.3% of gross domestic product — roughly £3.5 billion — is the Treasury equivalent of small change. Income tax brings in £128 billion.

It is not just oil that is going up. Average earnings in the latest three months were 5.2% up on a year earlier, the strongest rise for almost three years. The return of City bonuses played a big part in this, but the underlying trend is also plainly upwards. Some would say that with unemployment so low the surprise is that it has been so long in coming.

The Bank, in its quarterly inflation reports, has always tended to predict a rise towards the target and often beyond it two years into the future. So it did last week, but with rather greater urgency. The monetary policy committee (MPC) is not panicking over inflation, but it no longer has to work very hard to predict an increase, or to justify further interest-rate rises. The default position for rates is now that they will reach 4.75% by the end of the year and 5% or slightly more next year.

Mervyn King, the Bank governor, made an interesting suggestion that there might be no such thing as a capacity limit for the economy, on the argument that the faster it grew, the more people would be drawn here from other countries to work. But the MPC is still working on the basis that such limits exist and that we are getting closer to them.

There are other issues for the Bank. Some prices that have been falling for years, for example cars, are now rising again. The strength of demand has allowed companies to rebuild their profit margins.

Most of all, of course, there is a whiff of inflation in the air.

Petrol is probably the most visible price in the economy, it being impossible to drive down the road without seeing it up in lights next to a forecourt.

House prices, also very visible, are rising strongly, despite the best efforts of the Office of the Deputy Prime Minister to produce a more muted picture. Rising mortgage rates, which households see as a cost, are also obvious.

So is this the return of inflation in Britain? There are plenty of arguments against. In our post-industrial economy, oil’s effect on inflation is much smaller than it was even 10 or 15 years ago.

Take out bonuses, and earnings are rising by less than 4% — not enough to worry anybody much.

Most powerful of all is the persistence of low inflation. This has been around its old 2.5% target for more than a decade. All the signs are that it will take some shifting. And with inflation on the new consumer prices measure just 1.1%, surely worries over inflation are misplaced?

All that is true. The big danger is one of expectations. If wage- bargainers start to believe inflation is heading significantly higher and settle accordingly, that would be a problem. If companies start to raise prices both in response to and in anticipation of higher costs, that would be another.

One additional difficulty is that, while inflationary expectations were closely anchored to the old 2.5% target, few know what to make of the new measure.

None of this need mean the return of inflation. Fed chairman Alan Greenspan’s rule of thumb, that policymakers should aim for an inflation rate that does not distort economic decisions, is likely to be upheld in Britain. We are talking, after all, about inflation moving into the 2%-3% range from just over 1%. But the risks are greater than they have been for a while. So is the need for vigilance.

PS: Such has been the response to my request for informal economic indicators that it would be wrong to deal with them in a few paragraphs. They deserve a piece on their own, which I shall do very soon.

Just to whet your appetite, however, here is a taster. Many readers, touchingly, think I should not abandon my skip index because it is telling us, accurately, that the economy has slowed down sharply. Tied to this is what might be called the “one-handed economist” index. The moment that every economist is convinced the economy is on the up — as they are now — is the time to get ready for a big downturn.

There are others, although I foresee measurement problems with some of them. The “bump index” — the number of expectant women as a sign of economic confidence — is one, although it is probably a lagging indicator. Another is the number of jokes doing the rounds on office e-mails, a sure sign that people do not have enough to do.

The list goes on, and all will be revealed soon. But please do not let this stop you submitting further suggestions.

From The Sunday Times, May 16 2004