Keeping the threat of inflation at bay

The UK economy may seem buoyant, but the dangers of inflation remain a hot topic. Exactly how big is the threat, asks Dennis Turner

Inflation has dominated the summer’s economic headlines. Both the old retail price index and the new consumer price index (CPI) measures are above their respective targets (2.5 per cent and two per cent respectively), at 3.1 per cent and 2.5 per cent. With gross domestic product growth in the second quarter coming in at an above-trend 0.8 per cent, interest rates were raised for the first time in two years in August, to 4.75 per cent.

The key issue influencing future rate movements is how real is the inflation threat? Are the current numbers a precursor to an energy-induced upward surge in prices that will revive the old wage-price spiral? Or does the data give a misleading view of what is happening?

There are various routes through which inflation can affect the economic system. In the first half of the year companies faced higher input costs, for raw materials and energy in particular. These costs were up almost 14 per cent from the previous 12 months. Yet these same companies’ output prices increased by only 2.9 per cent, indicating that they found some way to absorb the higher costs.

Containing labour costs, reducing staff or squeezing margins are the most obvious ways to avoid passing on higher costs as higher prices. The competitive UK market makes containing prices vital for most managements.

Households have also been in the firing line with double-digit rises in energy bills. Today, energy costs account for half of CPI inflation. The rate excluding energy would be just 1.1 per cent, down from 1.6 per cent six months ago. Unless there is another hike in prices, the influence of energy on the annual rate will drop out of the numbers in the next few months. So, while the inflationary pressures are clearly there, companies are trying to manage them and households may already have seen the worst of them. For the policy-makers, however, it is the ‘second round’ effects that matter.

Even when unemployment was fluctuating, the annual rate of earnings growth stayed within 4.5 per cent. There were three main reasons for this.

First, the industrial relations legislation of the 1980s reduced the chance of a return to the bad old practices of the 1960s and 1970s. Second, growth has largely been in the less-unionised service industries, with manufacturing, the stronghold of traditional trade unionism, diminishing in size. Finally, the influx of migrant workers meant the supply of workers kept pace with the increasing number of available jobs, helping to keep a cap on earnings growth. Now that unemployment has started to rise and the labour market is loosening, these ‘second round’ effects are less likely to come through.

But a little bit of inflation soon becomes a bigger bit and, before you know it, base rates are moving upwards, destabilising the economy in the process.

Current policy has seen the UK record 56 consecutive quarters of growth, a period of sustained growth unprecedented since records began in 1870. As a result, we are enjoying the UK’s highest ever employment rate and it is five years since base rates last reached five per cent. Worrying about the first digit after the decimal point at least ensures the first digit does not become a problem.