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Inflation May Top 3 Per Cent but We Are a Long Way From the 1970s

Posted on: Wednesday, 14 September 2005, 09:00 CDT

HAS inflation come back to haunt us the way it did in the 1970s? As a result of the new oil shock, inflation in Britain rose to an annual rate of 2.4 per cent in August. This is the highest rate since the start of the modern statistics in January 1997, and well above the EU average.

Worse, it is significantly over the Bank of England's inflation target of 2 per cent, set in law by the Chancellor of the Exchequer - which means the likelihood of further interest rate cuts is growing remote. Should we start to get worried?

Once upon a time, during the last great oil shock of the 1970s, inflation became a ravenous monster eating the heart out of the British economy. During that decade, UK inflation averaged more than 13 per cent per year, peaking at 27 per cent in 1975.

If you were on a fixed income, you were in serious trouble. Industry was battered both by the resulting industrial unrest and by the inability to predict investment returns when prices were haywire. Industrial productivity growth collapsed from about 2.5 per cent a year in the 1960s to about 0.2 per cent a year between 1973 and 1979.

However, even with oil now costing dollars 70 a barrel, it is far too soon to compare today's inflation to that of the 1970s. A rise of 2.4 per cent in 12 months is tiny when set beside 27 per cent. In fact, over the past ten years, the total cost of living in Britain has risen barely 14 per cent in total.

Nevertheless, with global demand in the oil market still intensifying as a result of an insatiable Chinese appetite, and with the impact of Hurricane Katrina having knocked US refining capacity for six, we must expect further cost pressures. Last week, British Gas raised its UK domestic prices by 14.2 per cent. What will inflation do next?

Expect UK inflation to break the 3 per cent barrier. At one percentage point above the official inflation target, that would ring major alarm bells and officially require the Bank of England to write a letter of explanation to the Chancellor. That has not occurred since the present monetary policy system was set up in 1997.

However, 3 per cent still seems a very minor rate compared with the 1970s and hardly justifies panic buying and queues at the petrol pumps. The fact is that while oil prices have doubled in the past 18 months, their impact is much more muted than 30 years ago and should continue to be so.

First, oil makes up a smaller fraction of industrial costs than it did a generation ago. Oil intensity in the UK - the amount of oil needed to produce a unit of output - has fallen by a third in the past 20 years. And with the average delivery lorry managing only six miles to the gallon, we can improve on that.

Second, manufacturing makes up a much smaller part of the economy than it did back in the 1970s - these days, more folk in Scotland work in the financial sector than in manufacturing.

Third, there are huge countervailing forces that offset the jump in petroleum prices. The retail price of mass-produced manufactured goods has been plunging: clothes prices are down by 42 per cent in the past decade, shoes by 31 per cent and consumer electronics by 63 per cent. This is the result of countries like China, with a limitless supply of cheap labour, entering the global trading network.

Put all these factors together and you get more deflation than inflation. Yesterday's consumer price inflation news hid a surprising fact. The annual increase in manufacturing costs (factory gate prices) actually fell to 3 per cent in August, down from 3.1 per cent in July.

In fact, there is a school of economists who think the whole issue of inflation in the UK is being exaggerated as a result of using the wrong numbers. Two years ago, Gordon Brown switched the method of inflation accounting used in the UK from the old Retail Price Index minus mortgage interest payments (RPIX) to the new- fangled Consumer Price Index (CPI) used by the European Central Bank.

The CPI measure puts a higher weighting on energy prices than the previous RPIX. As a result, inflation as measured by the CPI is more sensitive to the recent oil price movements. The CPI has shown a dramatic acceleration from 1.1 per cent to 2.4 per cent over the past 11 months.

The old trusty RPIX inflation fell over the summer because it takes more account of housing costs (which the European Central Bank finds too difficult to compute for the EU as a whole). The RPIX index fell to 2.3 per cent in August, from 2.4 per cent in July, despite the oil price increases. If the Chancellor had not changed his inflation measure, we would be publishing "inflation falls!" stories and the Bank of England would be heading for interest rate cuts, not rises.

Does all this mean we can stop worrying about inflation?

No, and for two reasons. First, the rise in oil prices transfers spending power from western consumers to the petroleum-producing countries. In the 1970s oil shock, that lost cash ended up in London banks and was used to buy houses in Belgravia or supersonic jets to bomb Israel. This time, most of the lost demand is being made up by the Chinese. World growth may slow but it won't falter.

The other problem is closer to home and potentially more serious. A rise in oil prices, even a steep one, is merely one product getting dearer. When the price goes up, everything else should adjust, once and for all. But that did not happen in the 1970s because of the onset of what economists call "inflationary psychology".

The general public did not trust the government to control inflation. As a result, powerful trade unions demanded huge wage increases. Firms granted these wage rises then recouped the outlay by putting up consumer prices. So a deadly wage-price spiral began.

If people feel inflation is getting out of hand (even if it isn't) and we see a return to strikes and secondary picketing, we could trip into that sort of inflation spiral. That is unlikely because the Bank of England now controls interest rates - rather than the cowardly politicians - and will put up interest rates to break the cycle. But the price paid in unemployment could be high.

Why are prices up?

EXCESS DEMAND

Chinese demand is up 20 per cent over the past year. Traders are betting this rapid growth will continue for several years to come.

LOW STOCKS

Oil companies have tried to become more efficient and operate with lower stocks of crude. This means there is less of a cushion against supply interruptions such as violence in the Middle East, or recent strikes in Venezuela.

OPEC

The producers' cartel accounts for about half of the world's crude oil exports and attempts to keep prices where it wants by restricting supplies. Gordon Brown wants OPEC to pump more oil but many experts think the cartel has less oil than it claims.

SPECULATORS

Hedge funds betting on the possibility of higher prices have exacerbated price pressure in the market.

KATRINA

The hurricane has damaged a dozen US refineries at the peak of summer demand.

Source: Scotsman, The

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