Sunday, April 01, 2007
Firms flex their muscles to push up prices
Posted by David Smith at 11:00 AM
Category: David Smith's other articles


The other day I was looking for a shed for the garden. I say shed but what I had in mind was a palatial wooden building complete with double glazing and power supply for moments of contemplation.

Anyway, the point is that the salesman told me that I should get my order in quickly because the prices were about to go up by 10%. Being a canny kind of guy, especially when it comes to sheds, I checked. Sure enough, he was not spinning me a line.

Now this, to connoisseurs of the game played out daily between firms and customers, was quite unusual. As far as “things” are concerned — and I exclude houses from this — we have become used to prices coming down, not rising. As long as you don’t blink too soon, retailers will come down to your level.

Or so it seemed. Now it appears the game is changing. Buying ahead of price rises (I have not made my mind up on that shed) was something we used to do in the days of high inflation. For years now firms have faced extreme resistance from customers to higher prices; they have lacked pricing power. But things appear to be changing. You could say, and I apologise in advance for this, that firms are shedding their inhibitions.

The CBI says that manufacturers’ price expectations are at their highest since 1995. For consumer products they are at their highest since 1990.

There is a possibility that this may be overstating it, given that manufacturers have been under the cosh until recently but are now enjoying better times. But the Institute of Directors, in a survey covering business in general, says price expectations are at their highest for 11 years.

Why might this be? Economists, including those at the Bank of England, have long been looking for so-called second-round effects from the rise in oil prices over the past four years, which has resumed in recent days with the tensions over Iran. Mostly, those effects were expected to come through higher pay settlements, but that danger seems to have passed, for now at least.

Instead, the main second-round effect appears to be through the return of pricing power and, to be fair to the Bank, it did warn of the danger of this about a year ago. Put simply, it is easier for firms to force through price rises if they have something to blame it on, in this case dearer energy.

How worried should we be? Ian McCafferty, the CBI’s chief economic adviser, says we should be cautious about reading too much into the price-expectations data. In the past, the fact that a net 21% of firms (38% for consumer goods) plan to raise prices over the next three months might have been associated with double-digit inflation. Now it is likely to be associated with much more modest rises. Even so, that is in contrast to the falling goods prices we have been used to.

There is another important factor. Shop spending, which remains strong (though some retailers are suffering pain) is defying gravity. Official figures last week showed that real household disposable incomes last year were just 1.3% up on 2005, and that incomes in the fourth quarter were no higher than a year earlier. You have to go back a quarter of a century for figures as weak as this. Retail price inflation, at a 15-year high of 4.6%, is easily outstripping the rise in average earnings.

These are the ingredients, not just for a sharp slowdown in consumer spending, but for extreme buyer resistance to higher prices. Firms may try it on, in other words, but may end up with egg on their face. Next has a mid-season sale this weekend; Debenhams seems to have one most weeks.

The question for the Bank is whether it can afford to take a risk on consumer resistance. Several of the members of its monetary policy committee (MPC), who gave evidence to the House of Commons last week, are worried about the return of pricing power, and may be itching to fire another warning shot across the bows of firms planning to raise their prices.

We are back in the situation of January when the City expected a further hike in interest rates but did not expect it to happen straight away. Then, the markets thought the MPC would wait until February and the inflation report. Now, with rather less confidence, analysts expect the Bank to hold fire this week but raise to 5.5% in May.

Why wait? The “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs, sees no reason to do so. Its “vote”, ahead of the MPC meeting this Wednesday and Thursday, is 8-1 for an immediate rise. Two of its members think the hike should be by half a percentage point.

There are three significant things about the shadow MPC’s verdict. It sees the financial-market turbulence of a month ago as having passed, giving no reason for the Bank to delay. Its 8-1 vote is the mirror image of the actual MPC’s vote to leave the Bank rate on hold at its March meeting. And, as I have been pointing out, the shadow MPC’s predictive record has been very good; it anticipated each of the last three rate rises, including the surprises in January and last August.

Is there any reason to bet against the shadow MPC this time? Two members of the actual MPC, deputy governor Rachel Lomax and external member David Blanchflower, are unlikely to vote for a rise because of worries about the American economy and the sub-prime mortgage market. That, incidentally, is why one of the “shadows”, Patrick Minford, favours a cut rather than a rise.

How will the other seven on the Bank committee vote? I can see Charlie Bean, its chief economist, preferring to wait for a new forecast. I can also see three committee members, the new “hawks” Andrew Sentance and Tim Besley, together with John Gieve, the other deputy governor, seeing no reason to delay.

That would leave Mervyn King, Paul Tucker and Kate Barker as potential “swing” voters. Which way will they swing? Hard to say.

I would be inclined to wait until May but I’m also reluctant to bet against the shadow MPC. The chance of a rate rise this week has to be close to 50-50.

PS: Another bad set of balance-of-payments figures has once again raised the question — why don’t they seem to matter any more? Last year’s deficit is put at £43.4 billion, 3.4% of gross domestic product, up from £29.2 billion (2.4%) in 2005. The deficit in goods was a whopping £83.7 billion.

In cash terms all these numbers easily set new records, though as a proportion of GDP the current account was higher in the mid1970s (4%) and late 1980s (5.1%). But the question remains: why didn’t the latest figures provoke a good old-fashioned sterling crisis?

My usual answer is that what used to happen was that trade flows dominated capital movements, so a big trade deficit automatically put downward pressure on the pound, and upward pressure on interest rates. Now even big trade and current account gaps don’t matter as long as Britain continues to attract capital.

There is an additional answer, however, provided by Jim Tomlinson of the University of Dundee in a paper to the Economic History Society’s annual conference in Exeter this weekend. He points out that the balance of payments dominated the economic news from the 1940s to the 1970s, even though the current account was more usually in surplus than in deficit.

Despite this, the reason we appeared to lurch from one balance-of-payments crisis to another was, as Tomlinson argues, because the bar was set so high. The aim of policy was to run a large current-account surplus to pay for UK overseas investment and military spending abroad. When we fell short of these high expectations, the impression the public got was one of failure.

We may have beaten ourselves up unnecessarily, leading to a national inferiority complex, when the underlying picture was not that bad. After all, it took until 1982 before Britain ran a trade deficit in manufactured goods. The problem in that era was one of Britain’s overblown, end-of-empire ambitions. The problem now is that we just have a chronic deficit.

From The Sunday Times, April 1 2007


So do you think we are heading for Stagflation then? And what of your prediction that Oil will again go to $40 a barrel? Do you still stand by that? Or have you changed your mind? Saudi production is down 8% a year(voluntary?), mexican production is crashing and the North Sea is well past peak. Not looking good is it?

Posted by: Alex A at April 2, 2007 09:12 PM

No. We are a million miles away from stagflation. The world economy is strong and the UK economy is strong and firms are taking advantage of that strength to try to push up prices. They may succeed a little, but for the reasons I outline, they will also face resistance.

As for oil, it dropped below $50 a barrel briefly earlier this year, and has been buoyed, not just by the strength of the global economy but by some unusual discipline from OPEC and by geopolitical tensions, most recently over Iran. We are still in the spike. How long that spike lasts depends on a number of factors including whether the global economy continues to grow at a 5% pace, as it has done over the past three and a bit years. History would suggest that it should slow to something more normal, and perhaps slower growth in the US will help bring that about. But the global economy still has plenty of momentum. Oil spikes last for varying lengths of time. THe longest in recent times was in the first half of the 1980s -- 1978-9 though to 1984-5.

Posted by: David Smith at April 3, 2007 10:34 AM

A lot of M&A activity has taken place where the target market ie UK has been attractive.

As far as firms financial statements are concerned interest expense has taken root and firms are positioning for a steep rise in interest rates.Finance costs will feature prominently in every P&L account and smart companies will create a provision now for something they perceive is imminent.

No more will gross margins feature except where there is an exchange loss; but I feel finance costs will rise tremendously (already in the region of 7% per annum) and so far everything is colored "micro" with no macroeconomic effect until an equilibrium is obtained between hikes in interest rates and the relative strength of the GBP.

Posted by: Hitesh Damani at April 3, 2007 10:37 AM

I cannot vouch for conditions in the shed industry, but take a look at the latest detailed PPI figures. Although these again surprised on the upside in February, the single biggest upward factor was again recovered secondary raw materials (up 10.7% on the month), reflecting rampant demand for scrap metal from China. This alone accounted for more than half the 0.5% February increase in core output prices. However, this sub-sector represents just 0.632% of manufacturing. Thus, whilst there clearly is abundant evidence of pricing power in this tiny part of manufacturing, the same can most definitely not be said for the overwhelming majority of the sector. Indeed, for the remaining 99.368% of UK manufacturing, core producer output prices increased by less than 0.2% last month, with the headline measure rising by less than 0.1%. Talk of UK manufacturers (shed-builders aside) being able to raise prices in an attempt to expand margins looks a tad overblown.

Posted by: John Clarke at April 10, 2007 12:08 PM
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