Don't believe the inflation myths

What really causes inflation: higher energy prices or poor energy policy? Tax increases or others' refusal to pay? And is globalisation really putting downward pressure on prices? Brian Durrant explains.

Don't be fooled by headline figures the UK inflation background is worsening.

This January when it was announced that Britain's inflation rate was the highest for 16 years, the Chancellor was out of the country in India talking, amongst other things, about Big Brother. So the Prime Minister stepped in with an explanation. Now economics is not one of his strong suits but he played down poor inflation numbers saying: 'Inflation has risen not just in this country but in most of the major countries because of rising energy prices, rising oil prices, which have doubled or tripled over the last few years.'

In other words energy prices are to blame, all countries are in the same boat, and it is not his government's fault. Indeed he went on to say that the government is doing a brilliant job.

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The truth is rather different. In 2003 the Bank of England's target inflation rate changed to the Consumer Price Index (CPI). It was introduced as Gordon Brown's sop to Tony Blair when the Treasury rejected the Euro.

The index has many faults. Principally, it does not include house prices or council tax. But the index can be put to good use as it is constructed on the same basis throughout Europe. Accordingly it provides an objective comparison of Britain's inflation record relative to Europe.

What is driving UK inflation?

In the five years from 2000 to 2005, UK inflation had been notably less than that of the Euro zone. During that period UK inflation averaged 1.2%, while Euro zone inflation averaged 2.2%. But there has been a massive turnaround in fortunes. In the twelve months to December 2006 consumer prices in Britain rose by 3%. This is more than double the equivalent 1.4% rate in Germany and comfortably above France at 1.7% and the Euro zone as a whole at 1.9%.

How did this happen? The inflation environment did change last year in three main respects. Energy prices were pushed higher by global influences but the government was also to blame as it continued to fleece the taxpayer through higher indirect taxes and university tuition fees. But surely higher energy prices would affect European economies in a similar way. Well it didn't.

British families have seen their gas and electricity bills rise between four and five times more than the rest of Europe. Domestic electricity bills rose by 27% in 2006 and gas bills by 40%. On the other hand families in the Euro zone have seen electricity prices rise by only 5% and gas bills by 11%.

Why not just higher wholesale energy prices to blame

The increases are rather galling because the energy is often supplied by European firms; EDF of France supplies London and East Anglia and Germany's RWE owns nPower. For years the UK enjoyed cheap gas from the North Sea. But Britain is no longer a net exporter and is more at the mercy of nationalised monopolies in Europe. As we saw last winter these enterprises are not entirely profit driven. They were more keen to maintain supplies for their domestic market than sell to the highest bidder that was often the UK. As a result the gas prices were squeezed even higher.

Moreover the UK was unable to cushion sharp spikes in wholesale gas prices because its capacity to store gas was woefully inadequate. So although higher energy prices are partly to blame for the deterioration of UK inflation performance, the government's short-sighted energy policy was also a factor. So while Mr Blair was talking about "investment" in nurses, his government wasn't investing enough in the UK's energy supply infrastructure.

Now energy prices for households are coming down. Last month British Gas announced the first cuts in energy prices for six years bringing down gas prices by 17% and electricity prices by 11% from March 12, while nPower will cut gas prices by 16% and electricity prices by 3% from April 30. This is hardly a surprise. After all, wholesale gas prices have fallen more than 50% from last summer. But consumers should not expect the fall in their fuel bills to be on this scale. In the last three years wholesale gas prices have increased 170% whereas household bills have gone up 95%. Although household energy bills will come down this year, the era of cheap energy UK consumers enjoyed in the first half of this decade is over as our dependence on imports increases.

In the first half of this decade UK households enjoyed much cheaper energy than their European counterparts and this was a factor behind Britain's superior inflation performance. A fact, funnily enough, the government has failed to acknowledge.

Other factors affecting UK inflation

Meanwhile the figures show that the rise in UK inflation is not just about energy prices. Half of the 56 components of the consumer price index have inflation rates over 3% and only two of them are directly oil- related. There have been rising cost pressures specific to the UK and in many cases the government is to blame either directly or indirectly.

Increases in tobacco, alcohol and road fuel duties announced in the 2006 Budget pushed up the consumer price index by 0.13 percentage points. Meanwhile from last September, universities were allowed to charge up to £3,000 a year from a previous level of £1,175. The jump in tuition fees raised the education component of the CPI by 14% and added 0.24 percentage points to the inflation rate. Moreover as the new fees are paid by students who started last October, the rise in fees has been phased in over three years by the government statisticians, so we will see further jumps in the UK inflation rate in October 2007 and 2008.

Meanwhile although council tax increases are not captured by the government's chosen inflation measure, there is no denying that it is integral to our cost of living. Based on survey data for 2007 increases, council tax has risen by more than 90% since Mr Blair came to power in 1997, with annual bills rising from an average of £688 to £1,315. Over the same period retail prices have increased by only 30%. Predictably the lowest council tax increases this year are in the 238 districts that face local elections in May. Further evidence that the council tax is cynically used as a political instrument is that the £200 council tax rebate for pensioners was a one-off stunt in the 2005 general election year.

Why UK inflation experience is different

There are other impacts of government policy that make the UK inflation experience different from elsewhere. The UK pensions industry has been hit by a double whammy that has greatly increased costs. First in 1997, the Chancellor announced a much publicised £5bn tax raid on pensions, then the subsequent compulsion of company pensions funds to invest in less volatile but lower yielding bonds rather than equities. This additional money has to come from somewhere, either in the form of lower profits, less investment, job cuts... or rising prices.

The government's failure to enforce the law is also costing us dear. Here is one example. The number of people not paying road tax has nearly doubled in the past two years. Figures from the Department of Transport show that 2.2 million owners of cars failed to pay their vehicle excise duty in 2006. About 1 in 15 of the 33 million vehicles on the roads is untaxed. Moreover the DVLA estimates that 80% of untaxed vehicles have no insurance. Uninsured motorists are ten-times more likely to be convicted drink-drivers and are many times more likely to be involved in hit-and-run incidents. The incentive to avoid registering vehicles has mushroomed with the proliferation of speed cameras. Uninsured motorists add £30 to the average motor insurance premium.

In turn higher premiums deter increasing numbers from insuring their vehicles. It's a vicious circle spiraling out of control. Now although higher insurance premiums do not have a huge impact on the consumer price index per se, but the point should be noted that the cost of being a law-abiding citizen is rising inexorably by the day.

These unhelpful secular trends will, however, be disguised by a fall in the headline inflation rate expected this year. The inflation rate dropped from 3.0% in December to 2.7% in January on account of falling food prices, hefty discounts on furniture and lower year-on- year petrol prices and air fares. Lower household energy prices will come through in the spring and this should see the headline inflation figure heading lower still.

The Bank of England expects energy prices to fall by 20% this year and this will push headline inflation below 2% by early 2008.

Medium term inflation outlook less positive

Nevertheless the inflation outlook in the medium term is not particularly sanguine. Rudimentary monetarist theory states that inflation is caused by too much money chasing too few goods. Broad money growth as measured by M4 hit a 16 year high this autumn of 14.4%, though it has slowed somewhat to 13% in the twelve months to January 2007. In recent years broad money growth has been a better guide to asset price inflation rather than price increases at the retail level. Strong broad money growth this autumn foreshadowed the recent strength of house and share prices.

Indeed the strongest component of M4 lending has been to "other financial corporations". In November 2006 this was up 31% year-on-year. This lending has helped fuel the boom in hedge-fund and private-equity mergers and acquisitions activity. Ultimately the boom in asset prices spills over into service price inflation as the capital becomes one of the most expensive cities to live in. So the explosion of money growth gave the Bank of England an additional background reason to surprise the markets with an interest rate hike in January.

Indeed, in evidence to the Commons Treasury Committee on February 19, the Bank of England reiterated that the beneficial influences that have helped keep a lid on inflation, notably cheap Asian manufactured goods and immigration from EU accession countries could be on the wane. Moreover an adverse effect from globalisation is now being felt in the form of firmer commodity prices. The Old Lady also warned that sterling looks over-valued in the medium term. A weaker pound would raise import prices and stoke inflationary pressures.

To conclude, this year we will have the odd situation where we will be seeing headline inflation rates falling while at the same time the medium term inflation threat may worsen. Accordingly those who expect a fall in the headline inflation rate to be accompanied by a brightening of the interest rate outlook for borrowers are likely to be disappointed.

Editor's Note: A Cambridge economics graduate with nearly

25 years experience in the City, Brian Durrant is investment director of The Fleet Street Letter (founded 1938). He has worked in stock broking, the foreign exchange markets, and also headed the research department at one of London's leading futures and options brokers.

Brian has contributed to MoneyWeek with his expertise in investment strategy, for example how to quadruple your dividend income and how to navigate through the stock market in the 2008 financial crisis. He’s also touched on personal finance such as the housing market and the UK economy.