Why oil is no longer the biggest inflation worry

Lower oil prices may have made life a little easier for manufacturers in October, but unfortunately for those hoping for an end to interest rate hikes, oil is no longer the focus of inflationary fears. We are now seeing a more dangerous type of inflation - and falling oil prices might just make things worse.

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Life is becoming less difficult for manufacturers, according to inflation statistics.

The rate of growth in raw material costs eased up in October, helped by the drop in oil prices.

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You'd think that would be good news for those hoping there won't be any more interest rate hikes. But unfortunately, oil is no longer the focus for inflationary fears. The type of inflation we're seeing now is far more dangerous - and falling oil prices might just make things worse

Inflationary pressures facing manufacturers apparently eased up in October. Annual growth in input price inflation fell from 5.1% in September, to 3.8% (though that was still higher than analysts had expected).

The bad news is, the underlying cost of the goods coming out of the factories didn't follow suit. The headline rate for annual output price inflation fell to 1.7%, but 'core' output prices (which exclude food and oil costs, among other things) actually rose by 0.3%.

Now, here at MoneyWeek, we think it makes more sense to include all those volatile but important costs like energy and food when you're trying to work out what inflation's doing - but we've been in the minority, certainly while inflation has been rising. It seems only fair to assume that the Bank of England and all the other pundits who took comfort in 'core' inflation while oil prices were going up, will now be worrying about its steady rise, even as oil prices fall.

As The Times puts it, other surveys from the CBI and data from the Chartered Institute for Purchasing (CIPS) have shown 'a picture of rising output costs, caused by manufacturers reaping profits from the windfall of falling oil prices.'

This is the trouble with inflation. Long-term economic stability is important to companies, but not as important as turning a profit today. Picture this - you own a factory. For the past few years, your margins have been relentlessly squeezed by soaring energy prices, competition from China, rising tax bills and huge increases in the cost of raw materials.

But suddenly, energy prices drop off. What do you do? Slash your prices to match, in an effort not to contribute to rising inflation across the broader economy? Or put them up as high as the market will bear in hope of making back some of the margin you lost when costs were soaring?

We're assuming you opted for the latter. But will the market accept your rising costs?

Well, this is where it gets interesting. Because one of the flipsides of high oil prices - and one of the reasons that many pundits argued against interest rate hikes while oil was soaring - is that high oil costs can act as a tax on consumers and companies. It's not easy to find substitutes for oil, so most people have to grin and bear the extra expense of filling up their car or heating their home. That leaves less money in the pot for other things.

And if demand for 'other things' falls, then technically speaking, so should prices - which is to a certain extent backed up by the level of price-cutting and general cut-throat atmosphere in the retail sector in recent years.

But if petrol prices fall - and eventually household bills should too, though not for a while yet - then that puts money back in people's pockets. And as we can all see from our nation's debt mountain (£1.3 trillion and rising) the first thing the UK consumer tends to do when they get a bit of spare cash is think - 'Now what can I spend it on?'

So if debt servicing costs (which are dictated by interest rates) stay the same, then overall, the consumer has more cash, which increases demand for consumer goods. As demand rises, shops don't have to cut prices - in fact, they can raise them. And that's exactly what's been happening - the British Retail Consortium has reported annual shop price increases every month for the past four.

Eventually - and regular readers will know the drill by now - consumers notice shop prices are going up, they demand more wages to pay their shopping bills, companies put up prices to compensate for higher wages, and you get a wage-price spiral.

This is the nightmare scenario for the Bank of England. So how do you prevent this from happening? Raise debt-servicing costs (ie interest rates), so that the consumer doesn't start spending all this extra money, and shops can't put up their prices, because no ones buying.

We'll get a better idea of whether the Bank is thinking along those lines when it publishes the quarterly inflation report tomorrow. But we've got a feeling that whatever it says, it won't be pretty for those hoping that 5% is the peak for this interest rate cycle.

Turning to the stock markets...

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Losses in the mining sector yesterday cancelled the gains made by insurers, dragging the FTSE 100 14 points lower to a close of 6,194. Falling commodities prices meant that miners Antofagasta, Kazakhmys and Vedanta Resources were the biggest fallers of the day. However, insurer Resolution climbed over 5% on confirmation that it had entered early-stage talks over a possible takeover. For a full market report, see: London market close

Across the Channel, the Paris CAC-40 closed 43 points higher, at 5,490. In Frankfurt, the DAX-30 was 35 points higher at 6,393.

On Wall Street, stocks closed higher after positive remarks from a Fed official over the economic growth outlook. The Dow Jones closed 23 points higher, at 12,131, with Intel the day's biggest gainer. The Nasdaq closed at 2,406, a 16-point gain, although just off an intra-day high of 2,408, its best level in nearly 6 years. The S&P 500 was 2 points higher, at 1,380.

In Asia, the Nikkei closed 267 points higher, at 16,289.

Crude oil last traded at $58.56, whilst Brent spot was at $56.69 in London.

Spot gold rose as high as $627.10 in Asia trading, but had slipped back to $622.90 this morning.

And the world's largest mobile phone company, Vodafone, reported a first-half net loss of £5.1bn in London today. Despite half-year core earnings topping forecasts at £6.24bn, the company revealed an £8.1bn goodwill charge relating to its German and Italian operations. Chief Executive Arun Sarin reaffirmed that the company was on track to meet its full-year targets. Vodafone shares had risen by as much as 4% this morning.

And our two recommended articles for today...

Mid-term blues: it was the economy, stupid

- When the news came in from America's mid-term elections last week, the headlines were pretty clear on what had caused the Republicans' heavy losses: the war. But that isn't what the polls of voters really said, says Merryn Somerset Webb. Despite the great run the US economy has had over the past few years, the average American has seen their standard of living fall - and the situation could get worse. To find out why, read: Mid-term blues: it was the economy, stupid

The two key issues facing the global economy

- In today's mark-to-market world, when screens flash with a new piece of data, we react first and ask questions later. However, says Stephen Roach, economic data is only useful if we know how to use it - and keep your eyes fixed on the key macroeconomic issues. To find out what the most important trends you should be watching are - and what the data can tell us - see: The two key issues facing the global economy

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.