Costs and Prices
By Anonymous
There is little evidence that inflation expectations have increased over the past year, despite the rise in CPI inflation and the substantial increase in the price of oil. Wage settlements have edged up since the May Report, but average earnings growth has slowed. Oil prices hit a record high, and UK import prices rose in Q1. Manufacturing output price inflation slowed and, further along the supply chain, consumer goods price inflation remained subdued, despite rising costs in the distribution sector. CPI inflation has edged up to the 2% target.
Chart 4.1
Inflation expectations(a)
The outlook for CPI inflation is strongly influenced by the balance between the demand for private sector output and the available supply (Section 3). That balance partly reflects the degree of spare capacity in the labour market, which dictates the prospects for labour costs (Section 4.2). But it also reflects the extent to which companies are operating above or below normal capacity levels, which will affect production costs. These costs, together with import prices (Section 4.3), will influence the prices that companies charge along the supply chain (Section 4.4). And these developments in costs and prices throughout the economy will gradually filter into the prices of consumer goods and services (Section 4.5).
Prices and wages tend to be adjusted infrequently. So when people set wages and prices they will be concerned about what will happen to other prices in the economy over the period during which their own price or wage is fixed. As a result, inflation expectations are also a key determinant of the outlook for CPI inflation (Section 4.1).
4.1 Inflation expectations
Over the recent past there has been a number of developments which could have affected expectations of future inflation: CPI inflation has increased by almost 1 percentage point and the price of oil has increased by more than a quarter since September 2004. But is there any evidence that these developments have had a material impact on expectations?
Data from financial markets do not suggest that there has been any significant increase in inflation expectations. The difference between the yield on conventional and index-linked government bonds should reflect financial market expectations of inflation.(1)a But that difference will also reflect other factors, such as the premium investors are willing to pay to guarantee a certain real return. So bond market data can only provide an approximation to the true inflation expectations of market participants. Nevertheless, there is little compelling evidence of increased market expectations of inflation (Chart 4.1).
Table 4.A
Survey data on inflation expectations
Chart 4.2
Other forecasters’ expected probability distributions(a) for CPI inflation
There are a number of surveys which can provide information on inflation expectations. Broadly speaking, these surveys also suggest that expectations have been little changed over the recent past (Table 4.A). A net balance of retailers continues to expect the prices of their goods to fall over the very near term, according to the CBI survey. And surveys which ask about the prospects for retail or consumer price inflation over the next year have also been broadly stable – regardless of whether the survey sample includes the general public or economists and other professionals.
Even if people have not changed their view of the most likely outcome for inflation, they may have revised their view of the risks around that outcome. In other words, people may believe that there is a greater chance of a rapid increase in inflation than there was nine months ago, at the time of the November Report. But there is little evidence of any material shift in the balance of the risks in the data that the Bank collects from a sample of external forecasters each quarter. Each forecaster is asked to describe the probability that CPI inflation will lie in one of six ranges in two years’ time. As Chart 4.2 indicates, these outside forecasters have reduced the probability that they attach to CPI inflation being at or above 2.5% in two years’ time. And the latest data from outside forecasters (see the box on page 47) indicate that they continue to attach a small probability to CPI inflation being 2.5% or higher in two years’ time.
So why have inflation expectations not risen in response to the pickup in CPI inflation and the increase in the oil price? It could be that mounting evidence of a slowdown in consumer spending has led people to revise down their view of the prospects for activity, and therefore inflation. The stability of inflation expectations could also reflect the impact of the current monetary policy framework. As there is an explicit target for inflation, the public are likely to expect deviations of inflation from that target to be temporary. And that in turn will help to anchor inflation expectations, thus stabilising actual inflation.(2)a
Table 4.B
Private sector wage costs
Chart 4.3
Private sector settlements and earnings
Table 4.C
AEI and AWE(a) data on private sector wage costs
4.2 Labour costs
The average earnings index (AEI) suggests that private sector earnings rose by 3.4% in the year to May 2005, below the average rate of growth in recent years (Table 4.B and Chart 4.3).
Average earnings growth can be divided into the contributions from regular pay and from bonus payments. Regular pay growth has slowed since the May Report, particularly within the distribution sector, which has been heavily affected by the recent slowdown (Chart 3.5). In the economy as a whole, the bonus contribution has turned from positive to negative. Weak growth in bonus payments over the year to May depressed average earnings growth by 0.3 percentage points (Table 4.B).
The ONS has also published a new experimental measure of average earnings since the May Report: the average weekly earnings (AWE) measured.(1)b In principle, the design of the AWE should ensure that it provides a more reliable guide to the pace of average earnings growth than the established AEI. Over the recent past, the AWE has painted a broadly similar picture of private sector headline average earnings growth to the comparable AEI measure. Until recently, the two measures suggested different profiles for the growth in regular pay. However, in the latest data, both the AWE and the AEI reported similar rates of growth and indicated that regular pay growth had eased (Table 4.C).
Despite the slowdown in overall earnings growth since the May Report, there has been a modest pickup in pay settlements, as recorded in the Bank’s database. Settlements can be informative about inflationary pressure in the labour market. But there is a limit to how much weight one should put on these settlements data. The Bank’s settlements database only covers around a quarter of the private sector workforce, so may not be representative of pay growth across the private sector as a whole. The data are also subject to revision, partly because the Bank receives information on new settlements with a lag.
What matters to companies when setting prices is the cost of labour compared with the amount of output that labour produces – that is, unit labour costs. In other words, it is the balance between growth in labour costs and labour productivity that gives rise to inflationary pressure. In Q1, rapid growth in private sector earnings (Table 4.B) and weak growth in productivity (Section 3) led to strong growth in companies’ unit labour costs.
Chart 4.4
Spot and futures(a) prices of Brent oil
Chart 4.5
Market beliefs about future oil prices(a)
Chart 4.6
Import prices and the exchange rate
4.3 Global costs and prices
The price of oil
The price of Brent crude oil has reached a record high since the May Report, rising above $60 a barrel in August and averaging $58 in the fifteen working days to 3 August (Chart 4.4). That compares with around $40 in the equivalent period a year ago.
The futures curve suggests that the price of oil will remain around its current level for the next few years (Chart 4.4).(1)c But the probability that oil prices will follow the exact path suggested by the futures curve is very small. Options traded in financial markets provide a gauge of participants’ views about the prospects for oil prices. And those data suggest that financial markets believe that there is a greater chance of a large rise in the price of oil than a large fall (Chart 4.5). Currently, market participants judge that there is roughly a one in twenty chance that oil prices will be $100 or higher in August 2006.(2)c
Imports of goods and services
UK import prices were 3.3% higher than a year earlier in 2005 Q1, the highest rate of annual increase in import prices for four years. That largely reflected the continued recovery in import prices after their fall in late 2003 and early 2004 (Chart 4.6).
Around a quarter of UK spending on imports is accounted for by imported consumer goods and services. Over the late 1990s, these goods and services fell in price by around 10% following the substantial appreciation of sterling in the mid-1990s. During the past five years, they have fallen relative to the price of domestically produced consumer goods and services. The relative weakness of importprices partly reflects the impact of increased sourcing of goods from low-cost countries and trade liberalisation, as discussed in the May Report.
4.4 Sectoral costs and prices
Supply chain pressures in the manufacturing sector
Manufacturers’ input prices, which include the price of fuels and raw materials consumed by this sector, rose by 12.1% in the year to June, up 4 percentage points on the rate in May (Table 4.D). That was the fastest rate of growth in more than 25 years. Both the recent high rates of input price inflation, and the latest pickup on the month, can be largely accounted for by the increase in the price of oil. Manufacturing unit wage costs have also risen since the May Report as productivity growth in this sector has slowed.
Table 4.D
Manufacturers’ costs
Chart 4.7
Manufacturing output price(a) inflation
Chart 4.8
Service sector prices
The price of the goods that manufacturers sell to other sectors of the economy (manufacturers’ output prices) rose by 2.4% in the year to June. That was the slowest rate of increase in over a year, down almost a percentage point on the rate in April. The profile of output price inflation over the past year can largely be accounted for by changes in the contribution from two particular products – petroleum and metals-based goods (Chart 4.7). The prices of the inputs used to produce those goods – crude oil and metals – rose sharply in June (Table 4.D). That might imply some upward pressure on manufacturers’ output price inflation at a later date, though business surveys generally point to an easing of inflationary pressure in this sector.
Supply chain pressures in the service sector
The recent behaviour of costs and prices in the service sector has been mixed. Labour costs, which are the largest component of service sector costs, have risen sharply. In 2005 Q1, service sector unit wage costs increased by 3%, the largest quarter-on-quarter increase in more than a decade. However, more timely AEI data on service sector earnings suggest that unit wage costs are likely to ease in Q2. CIPS survey data, which have a broader coverage of service sector costs, point to easing cost pressures. The net balance of companies reporting rising costs fell for the fourth month in succession in July.
The ONS experimental corporate services price index (CSPI) – which measures business-to-business service prices – rose by 1.2%(1)d in 2005 Q1 (Chart 4.8). That was the fastest seasonally adjusted quarter-on-quarter increase in the CSPI in almost four years. But the net balance of companies reporting rising prices has fallen back since the May Report, according to CIPS survey data.
Supply chain pressures in the distribution sector
Developments in distribution sector costs can provide an early indication of movements in consumer prices. A key determinant of distributors’ costs is the prices that they pay producers for finished goods. So the pickup in manufacturers’ output price inflation over the past year will probably have led to an increase in costs for distributors. Unit wage costs in the distribution sector also rose sharply in Q1, reflecting the slowdown in productivity growth. Despite this rapid increase in costs, consumer goods prices have remained broadly flat over the past year (Chart 4.9). That could reflect the fact that distributors have been able to source goods from abroad, as previous Reports have discussed. But while the price of imported consumer goods continued to fall in Q1, data for April and May suggest they have stopped falling since then.
Chart 4.9
Distribution sector costs and prices
Chart 4.10
Oil-intensive items in the CPI basket and the pickup in CPI inflation
Chart 4.11
Distribution(a) of consumer price inflation rates
It may be the case that distributors have reduced the margin they charge over costs, perhaps as a result of increased competition. A compression of profit margins cannot persist indefinitely, so it is possible that upward pressure on costs could feed through to consumer goods prices at some point.
4.5 Consumer prices
CPI inflation edged up to 2.0% in June. Inflation averaged 1.9% in Q2 as a whole, a little below the MPC’s central projection in the May Report. Although CPI inflation has been stable and close to the target since the May Report, inflation has been as low as 1.1% as recently as September 2004 and was only 1.3% for 2004 for a whole.
One factor which could explain this recent increase in CPI inflation is the underlying pressure of demand on supply. Upward revisions to official estimates of output suggest that capacity pressures may have been acute in late 2003 and early 2004 (Section 3). So that could explain a broad-based pickup in inflation over the recent past.
Another explanation may lie in the continued increase in the price of oil. In April 2004, when CPI inflation was 1.2%, the price of Brent crude was below $34. Since then, the price of oil has almost doubled. oil accounts for a significant share of production costs for a small number of goods and services in the CPI basket (Chart 4.10). A large and permanent increase in the oil price is likely to lead to a rise in the price of these oil-intensive goods, and that may cause a temporary pickup in CPI inflation. In addition, oil price increases can raise the costs of producing a wider range of goods and services, also potentially contributing to a temporary increase in inflation. Higher oil prices can have more long-lasting effects on CPI inflation if they raise inflation expectations. But there is little evidence that inflation expectations have shifted (Section 4.1).
The relevance of both explanations can be seen by examining the distribution of inflation rates across the goods and services in the CPI basket (Chart 4.11). Greater pressure of demand on supply should affect a large proportion of consumer prices, and that should be reflected in a shift in the position of the distribution. But a large and persistent increase in the price of oil should lead the price of the oil-intensive goods to rise at a faster rate than other items in the CPI basket, reflected in a change in the shape of the distribution.
Table 4.E
Oil-intensive items in the CPI basket
There is some evidence of a shift in the position of the distribution of consumer price inflation rates since April 2004. But there is also evidence that the increase in inflation rates has been most pronounced in the upper tail of the distribution, where many of the oil-intensive goods are located (Table 4.E). So there is evidence that the pickup in CPI inflation has been driven in part by increases in the price of oil, and in part by the pressures of demand on supply.
What is less clear is how much of the increase in the price of oil since April 2004 has already been passed on into the price of these oil-intensive items. Increases in the oil price tend to be passed rapidly into higher petrol prices. But the prices of regulated industries, like gas and electricity bills, tend to be adjusted infrequently. The price of these services was set for many households at the turn of the year, so the current level of utility prices is only likely to reflect movements in the oil price up to the end of 2004. Increases in the price of oil since the beginning of 2005 may therefore continue to push up consumer prices over the short term.
(1)a For more details see Scholtes, C (2002), ‘On market-based measures of inflation expectations’, Bank of England Quarterly Bulletin, Spring, pages 67-77.
(2)a See the recent speech by King, M (2005), delivered at the Mansion House on 22 June. Available at: www.bankofengland.co.uk/ publications/speeches/2005/speech250.pdf.
(1)b For more details on the AWE see ONS (2005), ‘The new experimental measure of Average Weekly Earnings’, available at: www.statistics.gov.uk/articles/labour_market_trends/AWE_Aug05.pdf
(1)c See the box on pages 28-29 of the November 2004 Report for a discussion of the oil futures market.
(2)c This calculation assumes that investors are risk-neutral. For more details see Clews, R, Panigirtzoglou, N and Proudman, J (2000), ‘Recent developments in extracting information from options markets’, Bank of England Quarterly Bulletin, February, pages 50- 60.
(1)d This figure is based on a version of the CSPI which has been seasonally adjusted by Bank of England staff.
Copyright Bank of England. Economics Division. Bulletin Group Aug 2005