Jeremy Warner's Outlook: Latest Inflation Report is confused, yet one thing seems certain: another rate rise looms

Another profits warning from EMI; End of free banking looms as OFT acts
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The Independent Online

It was an uncharacteristically confused picture of the outlook for inflation and interest rates that Mervyn King, Governor of the Bank of England, presented at his quarterly press conference yesterday. This is no doubt mainly due to the fact that there is a known difference of opinion on the Monetary Policy Committee about the balance of risk to the economy. Were Mr King able to speak his own mind, rather than attempting to reflect the different strands of thought that exist on the MPC, you cannot help but feel that he would have been more straightforward.

As it is, he emphasised the remarkable degree of volatility in the inflation rate by the standards of the past decade and the challenges that this presents to policymakers. Up at 3 per cent just a month ago, it is expected to fall back to 1.5 per cent or less over the next year.

Just a month ago there was every possibility that the Governor would have to pen a formal letter to the Chancellor explaining why inflation had moved more than 100 basis points above target. Now, according to some City forecasters, he may be forced to write in explanation of the reverse phenomenon - a similar degree of undershoot.

In either eventuality, the letter would actually be a quite simple one to write. Rising energy prices were the main reason why inflation moved so far above target. With the mild winter and increased supply, energy prices have gone into reverse, causing inflation to fall back again.

The fact that inflationary experience in Britain seems to have been rather worse than in either America or Europe, both of which were subject to the same energy shocks, is explained by the peculiarities of our retail gas and electricity markets, which may more fully reflect the ups and downs of wholesale prices, but with sizeable lags.

In any case, Mr King invites us to look through the short-term volatility in the rate of inflation to the medium-term outlook. On this, the Quarterly Inflation Report is clearer. Inflation meets the 2 per cent target two years out, but only assuming market expectations for interest rates are met.

If rates were left where they are at 5.25 per cent, then inflation is forecast to overshoot target two years out. This invites the question of why, if the report is forecasting that there will need to be at least one more rise in interest rates to ensure inflation meets target, the MPC didn't just get on with it and raise rates at its meeting last week. Again the confusion which is creeping into policy is no doubt the result of split views on the MPC. As Mr King himself observed, there has rarely been so much uncertainty over the future path for inflation, both in the near and medium term.

My own gut feeling is that there is a lot more inflationary pressure in the system than policyholders care to acknowledge. It would also be even worse but for the relatively strong pound, which is keeping import prices low. The inflation rate is therefore quite vulnerable to any weakness in the exchange rate. Yet it is in the area of inflationary expectations that the real problem lies.

Rightly or wrongly, many people have started to believe that the real rate of inflation is a lot higher than the official numbers, based on the Consumer Prices Index, suggest. The measure that used to be used for inflation (the Retail Prices Index), which includes elements for mortgage and other housing costs, is already up at 4.4 per cent. And as the Governor concedes, indices that measure only frequently purchased items, ignoring the big ticket items such as cars, computers and flat screen TVs, are quite a bit higher than the CPI.

What's more, middle-class rates of inflation in London are likely to be higher still. The Governor insists that he must target the average of spending patterns as measured by the CPI. Unfortunately for him, it tends to be middle-class Londoners who are the most vocal in getting their message across about rising prices.

Add to that the current squeeze on real take-home income, and it is easy to see why everyone is clamouring for more pay. Seemingly, it is only high levels of immigrant labour in combination with low import prices which are keeping the lid on quite serious levels of inflation. The extra quarter point anticipated by markets may yet prove insufficient to bring matters to heel.

Another profits warning from EMI

At least there was something else to talk about amid all the self-regard of last night's Brits. With consummate timing, EMI chose the day of UK's premier music awards to announce another calamitous profits warning. It is the second such alert in five weeks, and although all the music majors are plainly suffering in the present, structurally challenged environment, on the available evidence, the situation at EMI seems to be rather worse than anywhere else.

The statement warns of a continued and accelerated deterioration in the all-important North American market. The physical music market as measured by Soundscan has apparently declined by a stomach-churning 20 per cent over the past calender year. The consequent high level of returns from distributors has had a crushing impact on gross margins. Physical piracy is part of the problem, but the main mischief is the continued inroads into a once-lucrative monopoly being made by the internet. Even where consumers can be persuaded to pay for their music, the amounts and margins are far lower than the music majors have been used to earning on the distribution system of the past - the CD. The consequent adjustment to once feather-bedded cost bases is proving a painful one.

Now back at the coal face having swapped the chairman's suite for the chief executive's chair, Eric Nicoli can at least be relied on to deliver on this front. Yet doubts about whether he's the right man to lead EMI into the fast changing reality in which the music industry now finds itself are bound to be heightened by this latest warning. In the City he is being widely likened to the former ITV boss Charles Allen - a competent enough businessman but somewhat lacking on the vision thing.

Mr Allen more than delivered on all the cost cuts he'd promised, but it failed to save him from the chop in an industry which is facing a similar degree of structural change to that of music. Mr Nicoli's position is made doubly precarious by the fact that he only so recently appeared to turn down offers well in excess of the present share price from both Warner Music and Permira.

But should Mr Nicoli resign? At the Brits last night he said: "Why should I?" Yet it seems unlikely he can survive for much longer. If Warner Music doesn't put him out of his misery first, perhaps it will be Roger Ames, head of Time Warner Music before it was acquired by private equity. He's been acting as a consultant at EMI for nearly two years and is widely acknowledged as one of the industry's top practitioners. Either way, EMI needs a saviour.

End of free banking looms as OFT acts

The banking season approaches once more, and though bad debts are rising, profits are still expected to be buoyant. Yet a black cloud in human form threatens to spoil the party. He's called John Fingleton, chief executive of the Office of Fair Trading, and any moment now he's expected to propose that charges on unauthorised overdrafts be capped at £12 a hit.

These charges are collectively worth well over £1bn a year in profits to the industry as things stand. A £12 cap will more than halve such earnings.

Still, though the threatened clampdown will be a headache for the banks, it is unlikely to prove terminal. Bank charges follow the waterbed principle - squeeze them down in one area and they tend to rise up somewhere else.

Current account holders should enjoy "free" banking and ATM use while they still can. It won't last. Mr Fingleton may succeed in putting the lid on overdraft charges, but only at the expense of destroying the "free" banking model. For those who keep their bank accounts in order, it hardly looks a decent trade off.