Is your weekly shop about to get a lot more expensive?

Until now, stable food prices have played a key role in keeping headline inflation under control. But with agricultural commodities prices set to soar, eating's going to get a lot more expensive in the near future.

Ten days ago the Bank of England sprang a surprise on the markets. It raised UK interest rates by a quarter- point. Most analysts said they saw it coming, but they'd expected the Old Lady to wait until the end of the year before tightening policy.

So the move provoked sharp reactions in the financial markets. The FTSE100 index tumbled 93 points and the pound reached a one-year high. Not even last week's news of a foiled terrorist plot to kill 4,000 air travellers could compete for volatility in Britain's finances.

But should the markets have been so surprised by the BoE's decision? There is plenty of evidence that the UK inflation outlook is deteriorating - fast - and on a number of fronts. Not even the Treasury or Bank of England can pretend everything's just fine any more. The trouble is that, over the last decade and more, we've become used to a unique set of circumstances that are now unwinding

Food prices: what has kept inflation down?

In previous economic cycles, inflation was much more sensitive to brisk economic conditions. Since 1992, however, the British economy has enjoyed a happy combination of steady growth without serious inflation. How come? Inflation pressures this time have been suppressed by two vital factors.

Firstly, the emergence of low-cost producers in Asia has lowered the price of our manufactured imports. More recently the influx of cheap labour from Central and Eastern Europe has kept the lid on our labour costs. As a result the Bank of England is one of very few government agencies in this country that has competently met its targets. She shouldn't be too quick to take credit for this, however.

The Old Lady is required to achieve an inflation target on the controversial CPI measure of 2.0%, subject to a margin of one percent o either side. The highest the targeted inflation measure has been since 1997 has been 2.5% - a level reached in September 2005 and again in June 2006, the latest figure we have. But as we pointed out to daily Reckoning readers in September last year, this is not everyone's experience of inflation under New Labour. An individual family's experience of inflation so far this century has depended crucially on how they spend their income.

Food prices: contrasting experiences of inflation

Consider two contrasting families family A and family B. The first lives in a large old draughty house in the country. It's in constant need of repair and is heated by oil-fired central heating. So their energy bills have risen by 25% since 1997. As the house is remote, so the family runs two cars. The children are educated privately and school fees have risen by 56% in the last 9 years.

Family A is not fussed by electronic gadgets or the latest fashions, however, but instead enjoys eating out, going to the theatre and taking holidays abroad. The cost of entertainment has gone up 34% since 1997, and holidays have risen by 45% since 1997.

Family B meanwhile lives in a modern insulated house in the centre of town. They do not go out for entertainment, preferring to stay in. The children are state educated, while the house is packed with audio- visual equipment, PCs and new domestic appliances.

Thanks to the emergence of those low-cost producers in East Asia, electrical goods prices in the UK have fallen by 62% since 1997. That leaves the family plenty of money to spend on clothes, but they tend to steer clear of luxury brands. The clothing and footwear they buy have fallen by 39% in price over the last nine years.

There are no prizes for guessing which family's cost of living has gone up more. In reality, of course, your own experience will be a combination of the two extremes. But it's plain to see how, on the one hand, we've all benefited from the influx of cheap manufactures from Asia...while at the same time energy costs and personal services have gone through the roof.

Food prices: budget-busting inflation

Gas and electricity bills in Britain have risen by 35% and 25% respectively in the past twelve months. Petrol prices have gone up 12% and private healthcare charges have risen by 7%. This runaway inflation in the basic essentials has been kept in an uneasy equilibrium with the falling cost of discretionary fashion and hi-tech items. But things are about to change...for the worse.

Until now, one key factor in keeping the lid on headline inflation has been the stability of food prices. Spending on food and drink, excluding catering and alcohol, accounts for 11% of a typical household's budget. This cost has risen by only 7% since 1997. But now there are ominous signs that food inflation is about to rear its ugly head.

From 1998 to 2005 the prices of processed food and non- alcoholic beverages rose by just 6.1%, constituting an annual increase of 0.085% a year. But in the year to June 2006 these prices rose by 2.5%. The same goes for unprocessed food, which increased by just 2.9% in the four years to 2005, but in the three months to June this year these prices have risen by 3.5%.

In short, food prices are finally taking off. There's more to come, too. Over the past three years the price of agricultural goods didn't participated in the general boom in other commodity prices. While industrial metals have risen 225%, energy prices by 92% and precious metals by 75%, the price of agricultural commodities - known as "softs" - has in fact declined by 10%. So there's a lot of catching up to do. Three factors will conspire to push agricultural prices much higher. They will finally destroy the benign impact of food inflation on your monthly budget, too.

Food prices: agricultural commodities prices to rise

First, once again, comes China. Chinese demand has driven the boom in metal and energy prices - so why not foodstuffs? China has already overtaken America as the world's leading consumer of wheat, rice and meat. And there is plenty of scope for growth.

Consumption levels per person in China are still well below Western levels. Today the Chinese consume less than 400kg of grain per head per year. But as their diets move to a Western style, rich in meat, dairy products and eggs, then the annual per capita grain consumption will move to become more like 900kg.

Secondly, the rising price of crude oil has encouraged the use of alternative fuels made from crops. Both the EU and US governments are desperately driving 'biofuel' initiatives forward. They hope to be seen as committed to the eco-agenda, whilst also lessening our dependence on volatile Middle East and Central Asian supplies of hydrocarbons. Brazil is often cited as a great example of biofuels at work, where half the cars run on ethanol, derived from sugar cane.

Now a sharp rise in biofuel demand is forecast in the next two years as ethanol plants using wheat as their raw material open in Europe. But as demand for crop- derived biofuels grows, so will competition for grains and sugar. That will only accelerate inflation in the cost of eating.

Finally this summer's hot weather in the Northern Hemisphere has wreaked havoc on grain production. The US has had the warmest year on record so far, and global wheat production has also been hit by the European heatwave. The US National Weather service now forecasts above-average temperatures for most of the country this month, while the drought in Texas is likely to intensify with implications for cotton production. Meanwhile Spain has cut its forecast for this year's wheat crop from 6.2m tonnes to just 5.6m tonnes a near 10% drop.

Food prices: why interest rates could rise again

Higher foodstuff prices are already coming through to your local supermarket's shelves. The British Retail Consortium reports a 0.44% increase in the price of food on average in July. That equates to some 6% annualised. And there is mounting evidence that retailers are having more success in pushing through price increases to consumers, after three years of trimming margins to stay competitive on the High Street.

In other words, Britain's inflation data in the coming months could well give the Bank of England good cause to raise interest rates again before Christmas. Last week, its governor - Mervyn King - warned that there was a 50- 50 chance of the targeted inflation number being above 3% during the next six months. And already there are further rises in gas and electricity prices due in the next few months. From September, universities will be able to charge up to £3,000 a year for tuition fees - up from £1,175 currently. The Bank of England thinks that will add 0.25% to the inflation rate in October.

That's on top of the coming rise in the cost of eating, of course the final 'cost of living' to start rising after energy and housing have shot higher.

By Brian Durrant for The Fleet Street Letter.


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