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In March, growth in the rate of inflation fell for the first time since July 2010. The Consumer Price Index (CPI) now stands at 4.0%, down from 4.4% in February. This will ease concerns that the higher-than-target rate of inflation was occurring due to medium or longer term effects rather than short terms shocks.
While the latest figures have provided the Bank of England with some room to manoeuvre, consumers are unlikely to feel any better off. Inflationary concerns coincide with rising product prices, sluggish wage growth and reduced public spending. The overall effect of these contributory factors is likely to continue exacerbating feelings of wealth reduction.
What are the key inflationary pressures and what are the likely impacts on business?
According to the latest figures, although inflationary pressure fell, there were still upward influences from:
- Transport
- Health
- Furniture and household goods
- Housing and household services
- Clothing and footwear
- Restaurants and hotels
- Miscellaneous goods and services
Therefore, upward pressure is still being felt quite widely across the economy. Theoretically, spending cuts and falling consumer demand, given real wealth reductions, should reduce inflationary pressure. However, while domestic contributors to inflation may be falling, there are still substantial international influences.
For example, the price of oil has recently been on the rise given the political instability in the Middle East. While the level of instability appears to have subsided, investors are unlikely to be so readily convinced. Conditions under the new regimes will need to be assessed given the period over which investments take place. This may mean that a majority of investors continue to steer clear of the region for the next 12-24 months.
Unforeseen inflationary pressures may also occur as a result of the earthquake and tsunami in Japan. Electronic components are already rumoured to be in short supply, which will inevitably increase the cost of electrical goods globally. Such costs will feed through to businesses’ costs, thus reducing margins or adding pressure to increase prices. Consumers, if price increases are implemented, will suffer both direct and indirect price rises as a result of such a shortage.
Another possibility is that inflation feeds through from countries, such as China, which are currently exhibiting significantly higher rates of growth than the UK and Europe.
Considering other possibilities, as stability in the Middle East improves the price of oil should reduce. This would feed through to UK businesses and consumers. Meanwhile, a squeeze on real incomes is likely to reduce demand for goods and services. Recent retail sales data and a number of profit warnings suggests that consumers are responding to the challenges of inflationary pressures. Such action will help to ease inflationary pressure, but is not conducive to economic growth.
The Bank of England’s view that spare capacity in the economy will bring down inflation in the medium term seems a real possibility. Given the tightening of living standards, an increase of interest rates at this time may apply undue strain on the economy. However, as has been demonstrated by the European Central Bank, there is a view that inflationary pressures are becoming more prevalent and monetary policy should begin to respond given its record period at low rates. As growth returns, it would be a mistake to allow the current loose monetary policy – part of the response to the banking crisis – to continue too long, as this is likely to fuel inflation.
So has the Bank of England’s spare capacity gamble paid off? Given the most recent GDP statistics and inflation figures, it would appear that their hard-line stance has given growth its best possible chance, achieving in the process a relatively low inflation rate compared to previous recessions. Meanwhile, the government has had to endure the political pain of public opinion from the implementing public sector cuts to control the deficit. This may ultimately help to drive inflation back towards target.
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