Economics: Inflation may be down for a long count

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THE January inflation figures are very good news. The drop to 1.7 per cent in the 'headline' rate was far better than City expectations, which had centred on a small decline from December's 2.6 per cent. The tumble shows that the recession is pushing inflation down a lot faster than the fall in the pound is pushing it up.

The lurch into new territory reflects sales, discounting, cost-cutting and job losses - in short, pain. But it should also help to support economic activity this year. Retail prices actually fell by half a per cent in January, even after allowing for the impact of cuts in mortgage rates. Including mortgages, the retail price index dropped by 0.9 per cent.

One positive effect for the economy as a whole is that money now goes further: each pounds 100 buys nearly pounds 1 more than it did a month ago. This rise in the real value of the money stock - the Pigou or real balance effect - should encourage spending. It is one of the economy's more powerful self-correcting forces.

The fall in prices also makes British goods more attractive to foreigners. Not only is the pound now 16 per cent below its level before it left the exchange rate mechanism on 16 September, but the prices of British goods and services measured in sterling are dropping. The gains in price competitiveness are being solidified rather than undermined, at least for the time being.

The most appropriate figure to use for international comparisons is the underlying inflation rate, which excludes mortgage rates (as other countries do). This annual rate - the rise in prices over the year to January - is 3.2 per cent, lower than the EC average rate of 3.7 per cent or the German rate of 4.4 per cent. The US rate is 2.9 per cent.

The Government's Teutonic 2 per cent inflation target now looks distinctly more attainable than it did in the wake of Black Wednesday. Equally good news is the fact that there is likely to be less scepticism about the Government's chances of steering within its 4 per cent ceiling for underlying inflation.

The price of gilts, paying a fixed interest rate that looks more valuable as inflation falls, bounced sharply. On Midland Montagu's calculation, the market's expectation of long-run UK inflation dropped from 5.3 per cent to 5.1 per cent in a day's trading. Another interest rate cut next month now looks more likely despite the pound's recent weakness.

After all, the fear of imported inflation as the pound drops must now recede. The Government could hardly have been driven to devalue at a better time. Import costs are rising as sharply as the pessimists predicted, but they are being more than offset by falling pay settlements and mortgage rates.

The first line of defence against the inflationary impact of a devaluation is importers' profit margins. Some optimists had fondly hoped that there might be a repeat of what occurred in 1981 and 1982, when the rise in import prices was much less pronounced than the fall in sterling. But on this occasion, the pound had been less overvalued. Importers' profit margins were not fat.

As a result, import prices have risen as much as sterling has fallen. Between August and December, the pound fell by 12.7 per cent. Over the same period, the rise in the unit value of imports was also 12.7 per cent. Two thirds of manufacturers' fuels and material input costs are imported, and the rise in input costs was 9 per cent - also bang in line with the fall in sterling.

This is not really surprising: for most overseas companies, Britain is only a small part of their total market. They are unlikely to shave their prices below what they think it appropriate to charge elsewhere, because the total market will have changed little. It is more surprising that there is so little sign of this rise in costs yet being passed on to consumers.

Within manufacturing, the explanation is the collapse in labour costs, which comprise three quarters of all costs in the sector. (A single company will not notice how important labour costs are, because it buys in so many components. But those components also include a labour cost.) The CBI pay databank shows that pay settlements fell to 2.8 per cent in manufacturing in the fourth quarter. Even the rise over the year in average earnings - which always declines more slowly than settlements because it embraces everyone, including those who settled for higher levels six months ago - is down to 5 per cent and is still falling.

Businesses have also been shedding labour, producing the same output with fewer people. This rise in productivity - output per head in manufacturing grew by 5.2 per cent over the year to November - has meant that there is now effectively no rise in the labour cost per unit of output in manufacturing. Total costs in manufacturing may be rising by as little as 2 per cent. In this context, the surprise is that factory gate prices have not slowed down more. The rise over the year to January was 3.5 per cent, allowing some rebuilding of profit margins.

Manufacturers are only part of the story. Many imports go straight to wholesalers and thence to the consumer. Here the cost rise is clearly feeding through: list prices for cars and other imported durables are rising. Retailers selling a high proportion of imports - like the electrical goods stores - have been complaining. But the impact of picky consumers is containing the overall effect.

The January retail price index figures are in line with what the gloomier retailers were saying after Christmas and the New Year. People are buying, but only if they are offered bargains. The spurt of spending in the sales was not due to happy days being here again, but to canny shoppers bringing forward purchases to take advantage of keen pricing.

Just how keen the pricing was can be seen from the detail of the RPI numbers. There are two big categories of sale goods, and both were marked down hard. The price of household goods dropped by 2.3 per cent in January alone, while the drop in the prices of clothes and footwear fell by 4.6 per cent in the month. The half percentage point fall in the index (excluding mortgages) is unprecedented even for January: last January, the decline was 0.1 per cent and that was unusual.

This good news on inflation could unwind rapidly once a recovery is under way. But there is a good chance that it will not, especially since the recovery is likely to be feeble. The underlying inflation rate may stay flat or even fall further for the rest of the year, while the headline rate is unlikely to rise towards the underlying rate until the very end of the year (when the post-ERM interest rate cuts drop out of the annual comparison). With low inflation and unemployment still rising, the autumn pay round may well ratchet downwards.

Pay is the key. The consensus forecast is for underlying price inflation of 4.2 per cent in 1994 with earnings growing by 5.4 per cent. But it is not impossible, for example, to imagine earnings growth of 4 1/2 per cent and productivity growth of 2 1/2 per cent. Even with higher profit margins, retail inflation could subside below 3 per cent.