Why the good news on inflation may not last

By Associate Editor David Stevenson Sep 09, 2008

David Stevenson

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Mervyn King

Cutting interest rates now is a huge risk

There were no doubt some serious sighs of relief at the Bank of England yesterday.

Finally, some good news on the inflation front – UK producer prices dropped by the most in at least 22 years in August. That's bound to encourage hopes of interest cuts more quickly than expected.

Before we all start to get too excited, there's the small matter of the plunging pound – and thus higher import prices - to deal with. Yet on the surface, the so-called 'factory gate' figures do look pretty good.

Prices charged by manufacturers dropped 0.6% from a month earlier, the first decline since October 2006 and the biggest since records began in 1986, according to the Office for National Statistics. And it was all rather unexpected, as the median forecast by the 29 economists surveyed by Bloomberg was a 0.1% increase. What's more, raw material costs actually declined by 2% from July, the biggest drop since January 2007.

So is inflation really heading for the back burner?

It might be a good idea to keep the champagne on ice. Despite the latest pull back, the year-on-year factory gate numbers still look horrible. Output prices are still almost 10% up on last year, while input costs remain in the stratosphere, 26% higher than a year ago.

That all points, by the way, to a real squeeze on company profit margins. Last week for example, DS Smith, the owner of the Spicers office products brand, was complaining that a combination of slowing demand and higher raw material costs has hurt first-quarter business.

Of course, it's not the Bank of England's prime job to worry about industry's profits, but about the headline inflation rate. The CPI -consumer price index - is currently at 4.4%, its fastest pace for a decade. It has been above the stated 2% target for 10 months. As Bank of England governor Mervyn King has already warned that CPI could be heading for 5%, which is so far away from that 2% that it's no longer funny, he and his team of rate-setters really need to be quite confident about price pressures beginning to ease before they start lowering official borrowing costs.

That said, because of the ever more parlous state of the economy, Mr King and his henchmen received a fair amount of flak for not slashing interest rates last month. These producer price results mean that now there's bound to be an increasing clamour demanding a rate cut soon. Particularly as oil prices, which climbed to a record high in July, have since dropped back sharply. Indeed, Brent crude was trading at below $102 a barrel by Mondays' close, which is a near 30% plunge from the peak.

"The peak in inflation is potentially moving through,'' says Matthew Sharratt at Bank of America, "it will allow the Bank to place greater emphasis on the downside risks to growth and potentially to cut rates in November."

Perhaps. But the big bugbear could now be different. The pound has plunged to its lowest level against the dollar for two years, and also to a record low against the euro. That makes imported goods more expensive and is certainly taking the shine off that oil price fall, as it means that we only see some two-thirds of the benefit.

And ever since the Chancellor's contribution to the economic debate, telling the Guardian that Britain faces "arguably the worst" economic conditions since World War II, the traders on the City's forex desks have been looking for any excuse to sell sterling further.

If they pick up any scent of weakness on behalf of the Bank, they'll be on to it like hawks… or maybe, vultures. And as an even weaker pound would clearly ramp up those import costs yet again, cutting interest rates right now is a huge risk.

Published in Economics | More articles by David Stevenson

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