Commentary: Inflation down but far from out

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Industry's fuel and raw material costs rose less sharply last month than the City expected, but it is too early to cheer about the prospects for inflation. The impact of sterling's devaluation since September appears to be coming through quite quickly enough.

Fuel and raw material prices rose by 7.7 per cent between September and December, according to figures from the Central Statistical Office. This is overwhelmingly a consequence of devaluation, since the price of about two-thirds of industry's inputs is set in foreign currencies.

Indeed, the figures suggest that the rise in import prices continues to be sharp. On the basis of yesterday's figures, it seems quite likely that the overall rise in import prices between September and December will be nearly 12 per cent, almost exactly reflecting the fall of sterling over the same period. In other words, the theory that importers would absorb some of their increased costs by cutting their profit margins, just as they did in 1981, was wishful thinking. This time, there was no prolonged period of sterling overvaluation before the fall. They did not have unusually high margins to cut.

If the pass through from the fall in sterling to the rise in import prices is so rapid, why are the analysts not more concerned about the inflation outlook? The answer lies in the reaction of companies at home. Academic studies suggest that it is normally at least four months before rises in raw material prices feed through to the prices manufacturers charge for their output. Yesterday's figures bear this out; output prices have increased by only 0.6 per cent since the pound dropped out of the exchange rate mechanism.

Output prices will almost certainly pick up noticeably in the next few months, and not only because input cost rises will feed through. Industry also brings in new price lists at the start of the year, while this month's devaluation of the 'green pound' (the special currency used to convert Britain's food prices into sterling from european currency units) will also put upward pressure on the index.

The impact is bound to be muted simply because domestic spending is still so subdued. But a gradual revival in spending and output during the year may alter the balance of risk for many financially hard-pressed companies. This in itself will not be worrying so long as it remains a once-off adjustment to devaluation. But if the trade unions successfully use higher prices to justify higher pay settlements, the impact on prices will not be one-off but will become embedded in higher inflation. Inflation may yet break through the Government's 4 per cent ceiling.