The Impending Inflationary Threat

Posted on 06/12/2010

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Bank of England

In its latest inflation report, the Bank of England stated confidently that:

Inflation is likely to stay above the 2% target throughout 2011, given the forthcoming rise in VAT and continuing increases in import prices. As the impact of those factors on inflation diminishes, inflation is likely to fall back, reflecting continuing downward pressure from the persistent margin of spare capacity.

My view however, is that the prices paid by UK households for essential goods and services are not so much determined by the Bank of England and its monetary policy, but rather by developments in global markets for key commodities (energy, food, etc) and micro-economic market distortions that are specific to the UK economy (housing, rail travel, etc).  Because of these factors, I take the view that “spare capacity” (a euphemism for unemployment) is unlikely to have little effect upon the rate of inflation.

Together food & beverages, clothing & footwear, housing, fuel and transport make up 59.3% of the UK RPI basket, so clearly these items have a significant impact on the overall rate of inflation.  As I will show, the outlook in each of these categories is for prices to rise, some by a large amount.

Housing currently makes up 23.7% of the RPI basket in 2010, having increased from only 15.7% in 1987.  Despite the fact that the house prices have been declining in recent years, prices still remain elevated and the UK has a severe structural shortage in housing, with the situation arguably worsening since Kate Barker published a detailed report on the matter in 2004 which concluded that the country was building 70,000-120,000 too few houses per annum.  Because of this structural shortage, house prices declines in the UK have been relatively small compared to other countries which suffered bubbles.  This, combined with low levels mortgage availability and rising demand due to demographic pressures is already forcing residential rents upwards, in some areas quite significantly.  The UK’s largest rental agency reported that the average rent was £691 in October, an increase of 4.5% on a year earlier and the ninth consecutive month of prices rises.  As might be expected, the South-East region saw the largest increases, with rents increasing 1.2% month-on-month.  This is starting to have some strange effects in London, with the Guardian recently reporting that competition is white-hot in the market for shared accommodation, with landlords running “audition-like” social events in order to select new “candidates” to let-out rooms.  The effect of “spare capacity” on the property market is almost nil given the severe shortage of homes in the UK, particularly London, so while the Bank of England worries about under-shooting its inflation target over the next few years the citizens of the UK are faced with rising living costs.

Fuel, motoring expenses and travel fares contribute 20.4% of the UK RPI basket at present, so oil and related commodities also have a major impact on the overall rate of inflation.  Oil prices, having already increased by 17% over the past year, are forecast by JP Morgan to rise from the current level of $89 per barrel to $95 per barrel next year and then to $105/barrel in 2012, so consumers and firms are likely to face rises costs over the next couple of years.  It is not just oil, the UK relies upon natural gas for a significant portion of electricity generation capacity and for use in the home.  However, the home energy suppliers have recently been raising prices due to increasing wholesale energy costs.  It is not just rising fuel prices that are driving-up transport costs.  The UK government has recently lifted the cap on regulated train fares, allowing the train operating companies to raise fares by between 30-40% over the next few years.  For commuters who live in the South-east, these sums will be significant.  For example, commuters from Canterbury to London already pay £3,880 per annum in 2010, rising to £4,376 in 2010.  It is not just train passengers that will suffer, as motorists can expect to see rising insurance costs as insurers raise prices after a decade of price competition in order to compensate for falling investment returns.  Price comparison website confused.com found that premiums in 3Q10 increased 37.5% over a year-earlier, a rise that is yet to fully-impact many drivers who are yet to renew policies at the new rates.

Spending on food and non-alcoholic beverages currently make up 11.2% of the UK RPI basket.  A rising global population, rising meat demand (which is more resource intensive) and the loss of farmland due to urbanisation are expected to combine to put upward pressure on food prices over the next couple of decades.  The OECD-FAO Agricultural Outlook 2010-19 finds that grain, livestock and dairy prices are likely to be around 40% higher in real terms in the coming decade than they were in the previous decade (ignoring the spike of 2007-08).

UK consumers currently spend 4% of their income on clothing and footwear and this too is a category in which price rises are expected over the coming year.  Next, one of the UK’s largest clothing retailers, has warned that it faces a “speculative bubble” in cotton prices and expects to pass these through to consumers in the form of a price increase of around 8% in 2011.  Regardless of the cause of the increases, it is another price rise facing UK citizens, and one unlikely to the impacted by “spare capacity” given the already wafer-thin margins of many retailers.

In summary, I have shown that the price outlook for goods and services encompassing around 60% of RPI basket is distinctly inflationary in nature.  This is before even considering the VAT increase which will add 2.1% to the prices of many goods and services, the weakness of sterling of the foreign exchange markets, and the rising wages of Asian factory workers that mean ever-cheaper consumer goods are likely to be a thing of the past.  Consequently, I fear that the UK is likely to see inflation remaining above the Bank of England’s target, and possibly increasing to the 4-6% range.

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Posted in: Economy, My Thoughts