Inflation figures may settle interest rate argument

New information out this week could tilt the balance of argument between the Chancellor and the Governor of the Bank of England over the need for higher interest rates.

Inflation figures will help solve "the puzzles about the strength in activity, money growth and domestic inflation" which the Bank of England highlighted in its Inflation Report earlier this month. The two questions the new data will help answer concern the scale of inflationary pressure and the risk of a pause in growth as manufacturers and retailers offload excess stocks.

Good news on inflation is likely to result from bad news on another front: the possibility that an inventory shake-out will bring the economy to a halt. The Bank of England warned of this in its Inflation Report, saying "the main danger is a downturn due to destocking".

A survey of fund managers conducted by Smith New Court and Gallup revealed that they were more optimistic about the outlook for UK base rates. The average forecast was for a rise to 7.0 per cent in a year's time, compared with a prediction of 7.2 per cent a month ago. Sixty-four per cent of mangers expected an improvement in the economic outlook compared with 48 per cent last month.

The first instalment in the week's batch of inflation figures comes with today's producer price figures. These will show whether the recent fall in commodity prices will bring input price inflation down into single figures, as the market expects.

Even more attention will be paid to factory gate inflation. The headline figure is expected to rise because it was so weak in July last year. However, the City is expecting the core rate, which excludes food, drink, tobacco and petroleum, to fall from 4.8 per cent in June.

If the rate stays put - or rises - this will suggest that the alarm over the possibility of an inventory correction may be overdone. The ability of manufacturers to push through bigger price rises would indicate that the build-up in stocks in the second quarter suggested by the CBI survey has been voluntary.

Geoffrey Dicks of NatWest Markets says that the increase in stocks of finished goods in the first quarter was the highest since 1979. Since output did not rise, the implication was that "manufacturers were cutting back on output in a bid to stop stocks from accumulating".

Retailers have been building up inventories. However, last week's CBI distributive trades survey suggested they ran them down in July. Sluggish growth has led to the suspicion that shops have used huge discounts to shift unwanted stock.

This could lead to a more favourable outcome to the key release of the week, the retail price index for July. The market is expecting the annual rate of headline inflation to pick up from 3.5 to 3.7 per cent and the underlying rate, which excludes mortgage interest payments, to hit 3.0 per cent.

But economists at BZW think that both rates may stay unchanged. "With retailers overstocked there must be a reasonable chance that they cut prices in an aggressive fashion."

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