Saturday, November 13, 2010

Inflation Squeeze

Are your pips squeaking yet?

Much squawking over British Gas putting up its prices by 7% - surely they're profiteering at our expense.

As so often, it depends which hand you use to look at it. On the one hand, wholesale gas prices have risen by 25% since the spring, so British Gas is being perfectly reasonable in passing it on. But on the other hand, the previous fall in wholesale prices was not passed on so it's a bit rich to pass on this latest increase.

The truth is that the energy companies have to earn a crust - ie they have to make a profit. They set their prices to us on the basis of prices in the world wholesale market. But the latter fluctuate all the time, whereas we consumers expect tariffs that stick around for a while. So the companies have to smooth things out by taking a view on future wholesale prices.

And they don't always get it right. This chart from Ofgem shows how their net profit margin per customer has varied over the last few years, from a peak of about £75 pa right down to a loss of £150.

Tyler fully understands that the energy companies are not our friends, and given half a chance would rip our faces off without compunction. But we cannot expect them to protect us from cost increases on the world markets where they buy their supplies. All companies have to make profits to pay shareholders for the use of capital. They are not - nor can they ever be - charities.

Unfortunately, it isn't just energy prices - what's happening in the energy market today looks horribly like a portent of what's about to happen right across our economy.

Consider. A couple of weeks ago we blogged the alarming explosion in world commodity prices. At the time we noted that the Economist's commodity price index was up by 35% over the preceeding 12 months in sterling terms. That was bad enough, but the picture now - just two weeks later - is even worse. After a further 6% hike in the last week alone, the 12 month increase in commodity prices now stands at a 1970s apocalypse-style 44%.


In just one year.

And understand this - the bulk of that increase has not yet fed through to us in our homes and high streets.

Meanwhile the inflation rate in China has jumped by nearly one percentage point in just one month.

Frankly, we're scared. What can we do?

We turn to the appointed guardians of the Pound in Your Pocket - the Bank of England. How do they propose to protect us against the inflationary dragons rising in the East? What do they have to say in their latest Inflation Report?

Here's what:
"... recent increases in commodity and other world export prices could lead to renewed upward pressure on inflation. That upward pressure could be heightened if some companies need to rebuild their profit margins, which were compressed during the recession...

...there is a risk that commodity prices will continue to rise. That would cause further increases in companies’ costs, and lead to higher inflation over the forecast period... That would also exacerbate the risk that the prolonged period of above-target inflation might cause companies’ and households’ expectations of future inflation to increase. That could feed into price and wage-setting decisions, offsetting the downward pressure on prices from spare capacity."

Could... would...?

Is and will, more likely.

The Bank must surely be getting embarrassed about these quarterly inflation reports. For as long as anyone can remember, their forecasts of inflation have almost always turned out to be too low - far too optimistic. We've blogged this many times (eg here), but just as a reminder, here is a selection of the Bank's forecasts, starting from February 2009 and ending with this week's. Focus hard and spot the pattern:

Chart 1 - Bank of England inflation forecast February 2009

Chart 3 - Bank of England inflation forecast November 2010

Spot it?

Back in February 2009, the Bank forecast that the inflation rate today would most probably be between 0% and 1%. They reckoned there was a 1-in-4 chance that prices would actually be falling (ie the Dreaded Deflation), and the chance of inflation being over 2% was put at well under 1-in-10.

Crank forward to February 2010 (just 9 months ago), and the Bank had nudged up their forecasts a bit - they now said inflation would most likely be between 0.5% and 1.5% by now. But they still thought there was a good chance of lower inflation, and still a 1-in-5 chance of deflation (despite the fact that the printing presses had been running in overdrive for a year).

And now? Well, today's CPI inflation has actually turned out to be over 3%. And even the Bank's own November forecast acknowledges it's back on a rising track.

And yet - despite their obvious inflation optimism in the past, despite their massive money printing, despite the further weakening of sterling, and despite the world commodity price boom - they still reckon that inflation will fall back below 2% pa within a year. It's almost as if they start all their forecasts from already knowing the answer - ie inflation will somehow soon be back below the 2% target.

Look, can we all agree on what's really going on here?

For years Britain has been consuming beyond its means, and in future we'll have to consume less. We're going to be squeezed. The real question is who's going to be squeezed the most?

Here's the abbrieviated list of squeeze options:
  • Squeeze the rich - aka raise the top rate of tax and execute tax avoiders - popular with the Grun, the BBC, and the Bishop, but the rich simply up sticks and leave
  • Squeeze the poor - aka means tested welfare cuts - very unpopular with the poor, the Grun, the BBC, and the Bishop, and looks like the same old Tories
  • Squeeze the middle class - aka general tax rises and universal welfare cuts - very unpopular with the middle class, the Mail and the Telegraph... oh, and the Grun, the BBC, and the Bishop as well
  • Squeeze the public sector - very unpopular with the public sector, the unions, the Grun, the BBC, etc etc
Now, if you're at the controls, you look at that and decide none of it looks altogether appealing - the losers are far too obvious.

But inflation, well, that's different.

You see, inflation is one of those things that not only spreads the misery far and wide, but you can also blame it on someone else. Ah yes, you say, those fiendish Orientals with their monstrous appetite for commodities... I gave them a damned good talking to in Seoul, but what can you do? They've made our lives a misery! And what about those crazy Yanks?! I haven't the faintest idea what they thought they were playing at with that huge printing press - it was sheer madness! All out of our hands though - we are victims of global circumstance (we'll conveniently overlook the fact that much of the inflation reflects sterling's 25% depreciation).

The Bank of England makes much of the fact that higher price inflation has not fed though to higher pay rises in the manner of a 70s wage-price spiral. And that is perfectly true - so far.

But while that may give some comfort on the prospects for inflation, it does nothing for those who are currently being squeezed by inflation itself. Obviously that includes pensioners and others whose savings income has plummeted, but it also includes those still at work. Because since the crisis broke back in 2008, inflation has already exceeded average pay growth by 2%, implying  a 2% cut in real living standards (even before taking account of higher taxes).

This squeeze is set to get worse as inflation ticks up. Those with inflation linked incomes (such as public sector pensioners) will be protected. Everyone else - including those still in work - will be squeezed.

So next time you get whacked in the wallet by some headline grabbing price rise, don't blame British Gas and don't blame Mr Sainsbury.

This is being done to you quite deliberately by those at the very top. Somebody has to pay, and they've decided it should be you.

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