Sunday, September 14, 2008
Inflation is poised to peak and then slide
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


On Tuesday morning at 10.30, an hour after the release of the official inflation figures, what is becoming a familiar ritual will unfold. Mervyn King will write to Alistair Darling explaining why inflation is so much above the official target.

He may say, as at the Commons Treasury committee last week: "Provided we do not impede the required adjustment, we will come through this temporary period and resume a path of normal economic growth with inflation close to target."

The chancellor will respond, saying he understands the Bank of England governor's difficulty, but has faith in his ability to get inflation back down.

These letters, available for all to read, are not in the Robert and Elizabeth Barrett Browning class but are an important part of the policy process. Tuesday's will be only the third in more than 11 years of Bank independence, and all three will have come in the latest 18 months.

The rules require a letter each time consumer price inflation rises above 3%, followed by another three months later if it stays there and so on. King's first letter, last year, said inflation would come down quickly and it did. He wrote in April and by July inflation was below the 2% target, though this was only a temporary respite.

His second, this June, predicted inflation would rise further, to "above 4%" in the second half, before it dropped back below 3%. He laid the blame on soaring energy and food prices.

What will he say this week? Inflation is rather higher than the Bank expected in June. This week's figure should show an August rate of 4.6% or 4.7%, with the prospect of 5% when the September numbers are published in a month.

The governor will point to sharp rises in utility bills, roughly 30% for gas and 15% electricity (compared with a regulatory cap of 5% and 2%, respectively, in France), and the pass-through from oil's summer peak of $147 a barrel. He will note food prices have continued to rise strongly, and in the official figures are up 13.7% over 12 months.

What he should also be able to say is that inflation is close to a peak. Though we will not know for sure for two to three months, a September inflation rate of 5% should be the summit, after which the rate will fall first gradually and then sharply.

That will be rather good news for state pensioners and others on benefits. Their annual uprating is based on September's inflation rate, though on the retail prices index rather than the CPI (consumer prices index) targeted by the Bank. By the time that uprating comes through next April, inflation should be dropping rapidly.

How can we be sure of that? Oil deserves a column in itself but I will wait until it breaks decisively below $100 a barrel. Last week Brent crude dipped below that level, with the main US-traded oil, West Texas intermediate, also falling, prompting a cut in production quotas by the Organisation of Petroleum Exporting Countries (Opec). We have to hope this attempt by the cartel to stop prices sinking below $100 fails.

Figures last week showed output price inflation measuring manufacturers' price rises "at the factory gate" fell from 10.3% to 9.7%, with core inflation sliding from 6.8% to 6.4%. Industry's material and fuel costs last month were 26% up on a year earlier but this was down from the peak in June, when there was a rise of almost 31%.

So pipeline inflation pressure is starting to ease. In addition, all six of the main energy companies have announced their big price rises, to take effect either in August or September. That means a higher inflation peak than King expected in June, but also an earlier one.

It is difficult to overstate the importance of inflation peaking soon and then falling. Sharply rising prices of essentials have a bigger direct impact on most families than restrictions on the availability of credit. Falling inflation will ease the squeeze on the growth in real incomes, though not by enough to offer retailers genuine Christmas cheer this year.

A monetary policy committee confident in its forecasts should have no qualms about cutting interest rates when inflation is high and rising, but that is not how it appears to work. It is no accident there has been no cut in Bank rate since before King's June letter. The last one was in April.

The Bank wants to be sure inflation is falling and that inflation expectations have not moved permanently away from the 2% target. Its own survey of such expectations, carried out by NOP, was published last week and contained mixed results.

The bad news was that people think inflation is 5.4%, the highest since the question was first asked in 1999, and above even the rise in the retail prices index (5%), let alone the CPI. Expectations are important, but mainly reflect what is happening now. As inflation falls, so will expectations.

The good news is that people expect lower inflation, 4.4%, over the next 12 months and that by a huge margin, 76% to 3%, are committed to low inflation, believing the economy will be weaker if it is allowed to take hold. Though Bank rate has fallen, people think by 63% to 7% that rates have risen. That is the credit crunch for you.

What are the risks that September will be a false peak and that inflation is more ingrained than the Bank believes? Sterling's fall from $2 to $1.75 deprives consumers of some of the benefit from the falling price of oil and commodities, which are denominated in dollars. Imported inflation is a danger, though weak demand should limit firms' ability to pass on higher import prices. Not only that, but China's inflation rate has dropped from 9% to below 5%.

Food prices are a risk, in the light of the dreadful summer and reports of very poor grain harvests in Britain. In general, though, such prices are set globally.

Finally, higher wages are a danger, not to inflation itself we no longer think in terms of a wage-price spiral but if they were to constrain the Bank from cutting rates. That would make King's adjustment even more painful. So far, settlements are remarkably subdued, which is good. They should remain so as unemployment rises. But with the unions getting restive the Bank will be watching.

PS: So who won the bizarre credit-crunch headline competition? First a detour. John Longley sent a collection of photos doing the rounds on the internet, including the Queen moonlighting at McDonald's and a Dragons' Den judge with a "golf sale" placard. I think they are mock-ups but you can never be sure. Andrew Zazzi was tempted by a 3.50 "all you can eat" Credit Crunch Brunch.

Many headlines talked of the problems the credit crunch was causing for pets. But, unless we've missed it, the iconic "Credit crunch ate my hamster" has yet to appear. Rohan De Silva sent in a formidable collection of genuine headlines, including "Credit crunch could fan fires", "The credit crunch and other biscuits", "Cheap chic how to look hot during the credit crunch", and "Boating floats on credit crunch".

The prize of a copy of The Subprime Solution by Robert Shiller goes to David Griffiths. Apart from "Noel Gallagher untroubled by credit crunch woes" and "Credit crunch desperation could be costing motorists their health", I liked a simple headline for our times: "Estate agent turns to prayer to beat credit crunch".

From The Sunday Times, September 14 2008