Sunday, October 21, 2007
Will soaring oil pump up inflation?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


It is not often you get a combination of low inflation and record oil prices but that is what we have had in recent days. Not only that, but the Bank of England’s monetary policy committee (MPC) considered cutting interest rates earlier this month. What’s going on?

Three months ago, when inflation dipped below the government’s 2% target, many were sceptical it would stay there. After all, it was only in the spring that Mervyn King had been forced to write an open letter explaining why inflation, at 3.1%, was too far above target.

Now, we have had three sub-2% figures in a row, the latest being September’s 1.8% rate. I have not heard King crowing from the Bank’s rooftops about this – he has had other things on his mind – but it has come as welcome relief amid his other travails.

The drop came in spite of a jump in food prices, particularly dairy products (I’ll devote a column to food soon) and petrol prices being up on a year ago.

Though many do not like such measures, “core” inflation, excluding food, alcohol, energy and tobacco, dropped to 1.5% last month, its lowest for 11 months. One worry earlier in the year was that core inflation was rising.

The consumer prices index (CPI) rather flatters Britain’s inflation performance. “Headline” retail price inflation was 3.9%, down from 4.1%. RPIX, the retail prices index excluding mortgage interest payments, put inflation at 2.8%.

This is still, however, very low in the context of an oil price of $90 a barrel. Last year, after a summer spike that saw the price touch $80 during the conflict between Israel and Lebanon, prices dropped sharply over the winter, falling to $50 by January.

Some see this happening again this winter, from a higher starting point. Supporting the price, however, is the strength of the global economy – this is a demand-driven price shock rather than one created by limited supply – and a considerable weight of speculative money.

The oil price and I go back a long way. Two years ago, as readers like to remind me, I wrote we were in a “spike”, and the sustainable price – based on real prices over 140 years – was $40 a barrel, not $80. In June I conceded this was a longer spike, perhaps similar to that between the late 1970s and mid1980s.

I reckon about a third of the current price is due to geopolitical tension, the flow of speculative funds into oil and other commodities, coupled with the decision by Opec (the Organisation of Petroleum Exporting Countries) to limit output. Another chunk, perhaps $10 to $20 a barrel, is due to the extraordinary strength of the global economy. This is the fourth successive year of 5% world growth. The International Monetary Fund (IMF) expects a fifth, merely shading its forecast down to 4.8% for next year, continuing the strongest run in living memory.

How long will these forces last? Hard to say. Alan Greenspan, in his book The Age of Turbulence, reminds us that forecasts of dramatic oil-price rises made at times of strain often come unstuck. In 1979, after the Iranian revolution, the US Department of Energy predicted a rise in the oil price to the current equivalent of $150 a barrel by 1995.

Greenspan has a word for those who believe global oil production is at its peak, saying: “There is certainly enough oil in the ground to meet a rise in world oil demand from 84m barrels a day in 2005 to 116m in 2030.” Whether supply will be forthcoming is, he says, a political, not a geological, question.

So far, the latest rise in oil prices has not had much impact, the recent petrol-price rises being as much due to the chancellor raising excise duty as the market. While oil is at a record in dollar terms, it is only revisiting previous highs when measured in sterling.

Current high prices, if maintained, will have an effect. Most of the rise in inflation we saw until earlier this year was directly and indirectly related to oil and other energy. The Bank could face a similar problem again, though this is where it gets interesting.

Retail sales rose last month by a strong 0.6%, suggesting consumers are not dead yet. But this was achieved by a fall in prices. Despite dearer food, average prices for retail goods fell 1.5% in the 12 months to September. Inflation could stay low even as a fresh oil effect comes through.

That is not the only conundrum for the Bank. Last week’s MPC minutes were interesting. They are signed off by the committee a couple of days before publication, and my sense is that members wanted to get a message across.

A speech by King a week earlier was widely interpreted as hawkish, but that may not have been the intention. Most of his talk was on Northern Rock; his comments on monetary policy were intended to be neutral, and the minutes were aimed at reinforcing that neutrality.

So the MPC has not made up its mind on whether to cut Bank rate. But it is alive to the possibility that it may have to act if its own analysis suggests the credit crisis will slow the economy too much.

The evidence is mixed. The latest Ernst & Young Item Club forecast is headed “Credit Crunch – What Credit Crunch?”, suggesting the economy will slow to 2.1% next year but that the effects will be contained. Gross domestic product rose by a strong 0.8% in the third quarter. A survey of UK chief financial officers by Deloitte shows the vast majority see little or no impact on their business. The question for the MPC is whether it will have enough information by next month to reach a decision.

There is another consideration for the MPC. I could have devoted a column to the IMF warning of a UK house-price crash. Instead I wallowed in a little nostalgia. This was almost the fifth anniversary of the first such warning from the IMF, in December 2002 (when house prices were below their long-term trend) and the crash or “correction” warnings have come thick and fast every four to six months since. The Washington body has discovered the elixir of generating headlines in Britain.

It could be that this is a “stopped-clock” forecast, which has to be right one day. This is, as I have written, a testing time for the market. I prefer to focus on the IMF’s caveats – it does not have a detailed analysis of the British housing market, and local factors such as immigration and housing-supply constraints will tend to support prices. But we’ll see.

PS: Will Alistair Darling bend on capital-gains tax (CGT), persuaded by John Hutton, business secretary? Some loftily say the CBI, Chambers of Commerce, Institute of Directors and Federation of Small Businesses are wrong and should accept this tax-raising “simplification”. No.

Darling’s CGT shake-up – which increased the rate for small firms from 10% to 18% and abolished indexation relief for pre1998 inflationary gains – was a significant error by the Treasury. Nobody outside its glass palace overlooking St James’s Park was consulted, as officials admitted.

It was a gift for the opposition. The Tories lost business votes in the recession of the early 1990s. Now they sense an opportunity. A report the party commissioned from the European School of Management attacked the CGT change and Gordon Brown’s earlier decision to raise the small firms’ corporation-tax rate from 19% to 22%. The tax system was becoming “significantly less competitive”.

Labour has spent 10 years trying to establish itself as the enterprise party. I had assumed Brown, in No 10, would go out of his way to show he was a friend of business.

Is there a way out? Darling could abolish taper relief and indexation but have two different tax rates, lower for business assets than second homes and other nonbusiness assets. But there would be an outcry from the new losers. John Whiting of Price Waterhouse Coopers suggests the Treasury could reinstate the retirement relief that was part of the original post1965 CGT system, shielding business owners who sell up to retire. Something has to give.

From The Sunday Times, October 21 2007


So many things going on...where to start. One thing is that GB & AD **are** the friend of business, it is just Big business they are friendly to, they ignore the small enterprise people (I know because I have been there). As for spending/inflation etc how much longer can it sustain itself based as it is on notional value of house prices? I read somewhere


that the average price is now 9 times average earnings. I know averages are misleading but it must tell us something.

As for oil surely this must feed through to almost everything as the transport costs are factored in?

Posted by: Iang at October 21, 2007 09:49 AM

Are we not selectively quoting Mr Greenspan? Didn't he suggest that inflation was looking to rise over the coming decades, with double digits becoming a reality once more?

Posted by: Werewolves at October 21, 2007 12:45 PM

No, the average home is not nine times earnings, that's a mistake, though they are high. I went through the numbers in some detail a few weeks ago:

"My reference last week to the fact that UK house prices are not 11 times average earnings, not much more than half that, brought a flood of responses, some quite rude. A disturbing number of people believe it. Let me set the record straight.

According to the Halifax, the house price-earnings ratio in June was 5.79. This is based on the Halifax’s average house price, £197,750, and its calculation for male full-time average earnings, just over £34,000, the traditional measure used to calculate the ratio.

Let me allow slightly higher numbers. Male full-time earnings were £30,763 in April last year. Uprating by 4% with the average earnings index gives £32,236. The government says average house prices were £211,341 in the second quarter, giving a ratio of 6.5. Taking male and female earnings, the denominator is £29,300 and the ratio just over 7.

How about median earnings? In April 2006 the median was £23,244 a year. To be statistically pure you need the median house price, £166,000 in England & Wales in 2006, on Land Registry data. That gives a 7.1 house price-earnings ratio. Against male earnings, £25,324, it is 6.5. These figures are high but they are well below 11."

As for Greenspan and double-figure inflation, he did appear to say that in an interview, though in a slightly obtuse way. It does not appear to be his view in the book, though my copy's in the office and I can't give you a definitive answer. Somebody else might be able to help.

Posted by: David Smith at October 21, 2007 03:54 PM

What is the effect of a stronger pound against the dollar If the US$ gets weaker does the price of oil not rise to compensate?

Posted by: James at October 21, 2007 11:50 PM

I cannot understand why the BoE shouldn't follow the Fed. Core inflation is down, with property / credit / taxes / oil & petrol combining to restrict available money, it is only a matter of time before retailers feel the pinch (post xmas hangover maybe?), but as we know when it is felt it is already too late.....the only thing that Mr.King seems to hold onto is the GDP figure, which in times of population expansion is surely meaningless? (I am a firm fan of GDP per capita).
We need to be more economy friendly, and have a precaustionary cut soon - November !

Posted by: Colin Flockton at October 22, 2007 09:12 AM

Colin - feeling the pinch on your mortgage are you?

Posted by: Sell Everything at October 22, 2007 09:38 AM


Forgive me if I am mistaken, but ddin't you say that oil prices would fall before Xmas? ...

Posted by: F.Fox at October 22, 2007 10:55 AM

I think we still have to wait for the effect of oil prices to feed into the system. The December and January inflation figures are what interest me the most.

Posted by: John@ScribbleSheet at October 22, 2007 11:59 AM

It will take a while before we know - this month's figures will give us some of the effect, however, including the increase in excise duty.

I don't recall saying oil prices would fall before Christmas, though that is what happened last year and there is often a seasonality about the oil price.

Posted by: David Smith at October 22, 2007 12:41 PM

Hi David

However we are only now starting to enter a period where Domestic energy is lower than a year ago. This will put a strong downward pressure (it will take 0.3% off the CPI in December) on the CPI over the next 12 months.

Posted by: kingofnowhere at October 22, 2007 01:01 PM

Well. All's well that ends well? Lets wait until February 2008 to see the significance of the slow down, the effect it has had on companies...and the pricing power it will then exhibit for the year going forward.

Inflation forecasters were significantly bitten when energy prices did make an upswing taking interest rates to the highest recently, and inflation at 1.8% should not be taken to mean all is well.

The way forward is to drag your feet on these numbers until significant signs of a slow down are forecast.

Posted by: Hitesh Damani at October 22, 2007 03:35 PM

House prices and immigrants heres a wee story happpening in Belfast the Polish are returning home too Poland because house prices are too high here!

By the way the polish are usually living 8 too a three bedroom house if that is not a sign of things too come i don't know what is ... now wheres my passport?

Posted by: Graham at October 25, 2007 07:01 PM

Mr Smith, given that 6 months or so ago you were forecasting oil @ approx $40 per barrel, what reason do you have to believe your new forecasts will be any more accurate?

Posted by: richard at October 27, 2007 05:12 PM

Why don't you read the piece before you comment? It does help.

Posted by: David Smith at October 27, 2007 05:56 PM

I don't see anything in the article about your $40 oil prediction?

Posted by: richard at October 29, 2007 08:43 AM

You're getting rather irritating:

"The oil price and I go back a long way. Two years ago, as readers like to remind me, I wrote we were in a “spike”, and the sustainable price – based on real prices over 140 years – was $40 a barrel, not $80. In June I conceded this was a longer spike, perhaps similar to that between the late 1970s and mid 1980s."

Posted by: David Smith at October 29, 2007 09:57 AM

I think your lack of predictive abilites stems from your implicit trust of the government stats. It is likely that a government that relies on spin and presentation on things like the 'WMDs launchable in 45 minutes' pre-treats economics stats similarly.

A narrow focus on the microstats at the expense of the macro politics compounds this problem - May I suggest that you subscribe to Dr Marc Faber's excellent newsletter, or read his book?

Posted by: richard at October 29, 2007 10:35 AM

Marc Faber is an interesting character, I don't suppose, however, you understand him any better than you understand anything on this site, let alone resorting to paranoid nonsense about 45-minute warnings.

Posted by: David Smith at October 29, 2007 07:16 PM

Nothing will pump up inflation - the cpi weighting is adjusted to whatever the goverment wants it to be. Something increases in price - weighting lowered. Something drops in price - weighting increased.

If you do a bit of basic research on the web, you will see when the cpi basket is adjusted & the trend in cost of the products at that time. Orange juice is one off the top of my head - price was set to soar, hence was removed from cpi basket.

How much longer can this continue, the people are now waking up to personal inflation of 7%+ per annum?

Posted by: LabourLieWatch at November 2, 2007 12:17 AM

Not true, I'm afraid. The CPI basket is adjusted in line with spending patterns in the Expenditure and Food Survey and other information. This sums it up:

Posted by: David Smith at November 2, 2007 11:12 AM

Using Male Full Time Average earnings is a cop out, and absolutely no use or relevance to a woman buying a home.

There is approximately an even balance of men to women ration in the UK - if it was 95% men 5% women then it would make more sense to use this measure.


Posted by: Kev M at November 7, 2007 07:03 PM