Inflation Squeeze

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%.

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 pricescould 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. Thatwould 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."

Hmmm...

Could... would...?

Is and will, more likely.

The Bank must surely be getting embarrassed about these quarterly inflation reports. For 2 years now their forecast of inflation has alwaysturned 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 2 - Bank of England inflation forecast February 2010

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, anddespite 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 headline grabbing price rises, 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.

THURSDAY, NOVEMBER 11, 2010

Making Work Pay

So much for Labour's jobs boom

All credit to IDS for pressing on with his welfare reform package in the face of a bare fiscal cupboard.

He hasn't been able to achieve quite as much as we'd hoped and proposed back in the summer (see here), but he has managed to hold on to the crucial central feature of any meaningful reform of working age welfare - that work should always pay.

Under his planned Universal Credit the poor will no longer face effective marginal tax rates in excess of 80% (ie they will no longer lose 80 or 90 pence or more of every extra pound they earn). Instead, the maximum any of them will lose is 76%.

Yes, that is still far to high - much higher than the 55% fixed maximum we incorporated in our own proposal. But the Universal Credit is much simpler than the current impenetrable morass, and that will eventually save administration costs and cut the losses from fraud and error. And at last it offers the poor some certainty - certainty that they will always be better off working than not working.

Here's how it looks for two key groups - single people, and couples with two children. The charts show how their net incomes increase according to how many hours they work, assuming they are earning the minimum wage. We can see how both groups are almost always better off under the new system compared to the existing arrangements, and that they are always better off working more hours:

Moreover, IDS has pledged something our proposal did not offer - that nobody will be any worse off under his plan than under the current system.

Clearly that is a very reassuring promise, but it is also very expensive. Which is why we didn't propose it, and why, despite the additional £2bn IDS has set aside to smooth implementation, there is not enough money to fund lower effective tax rates.

As we have discussed many times, there are some extremely difficult choices here. Everyone wants to cut those high effective marginal tax rates in order to provide a compelling reward for working. But it is hideously expensive - our own calculations suggested that to cut the effective tax rate by 10 percentage points would cost £10 - 20 bn pa.

So in these tough fiscal times where are we to find the money? Our answer was to cut the official definition of the poverty line from 60% to 50% of median income, which we reckoned would save £20 - 30bn pa. And that would fund a substantial cut in marginal tax rates, making work much more attractive to the poor.

IDS has shied away from such a dramatic change. The White Paper reports that DWP have studied our proposal but they don't like the prospect of"substantial numbers of people in vulnerable situations losing entitlement".

And that is the nub of the problem.

We find ourselves with a welfare system that has rewarded poor people for not working. 6 million of our working age poor are now dependent on welfare rather than their own earnings. And we all agree that we must rebalance the incentives so that work is always going to be the more attractive option.

But we simply don't have the cash to focus the entire shift on increasing the reward from work. The horrible truth is that in one way or another we will have to find some way of cutting the current level of welfare provision for the able bodied poor.

We certainly welcome the IDS reforms, which undoubtedly point us in the right direction. But we should be under no illusions - some even more difficult decisions still lie ahead.

Britain's Trillion Pound Horror Story

Durkin's the one on the left... physically, that is

Essential viewing at 9pm tonight on C4.

The latest film by Martin "Great Climate Warming Swindle" Durkin is on one of BOM's core subjects - our huge national debt.

It's called Britain's Trillion Pound Horror Story, and the blurb says:

"Film maker Martin Durkin explains the full extent of the financial mess we are in: an estimated £4.8 trillion of national debt and counting. It's so big that even if every home in the UK was sold it wouldn't raise enough cash to pay it off.

Durkin argues that to put Britain back on track we need to radically rethink the role of the state, stop politicians spending money in our name and introduce, among other measures, flat taxes to make Britain's economy boom again."

If it's anything like Durkin's climate film, it should be a rattling good view.

And yes, congratulations to C4 for giving us a rare prime time chance to hear just why we must stop politicians spending money in our name. Can't imagine the BBC ever doing that.

PS I presume we are going to have proper prosecutions and punishment for the screaming rabble who smashed up Millbank yesterday. We have stacks of video, and identification looks pretty straightforward. So no wimping - we need proper action against these people, including an end to any further taxpayer support for those convicted. We cannot have taxpayers robbed by violent mobs, and we need to make that clear right now.