Inflation test about to begin

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The great inflation test is about to begin. For three or four years inflation in Britain has consistently been lower than the consensus had forecast. But that was the easy part. Experience the unpleasant surprise of the longest (though not the de epest) recession since the Second World War and you are likely to have pleasant surprises on the other side of the equation. Even during the present expansion, also much faster than forecast, inflation has been held down by the gap between productive pot entialand actual economic activity generated by the recession.

Finally there is the international dimension. Britain's achievement in crunching down on inflation took place at a time when world inflationary pressures were muted, largely in response to the global economic slowdown.

But now all these favourable forces seem to be weakening. It is not just that we are in a different position in the cycle. So, too, is the rest of the world: the US expansion is strong and mature; most, not all, of continental Europe is growing fast; even more rapid growth is occurring in the many newly industrialised economies; and even Japan, the last of the large economies to pull out of recession, seems at last to be showing some growth. So not only has our output gap narrowed, which on th e face ofit ought to herald a rise in inflationary pressure, so too has the corresponding gap in the other main economies.

The markets have been aware of this for some time. The commodity markets tightened sharply in the first half of last year - one explanation at least for the collapse of bond prices last year was a reassessment of the danger of inflation; and the rises ininterest rates now being imposed have been justified on the grounds that they are meeting such pressures in advance. But up to now the evidence of inflationary pressure, as opposed to evidence of the fear of it, has been slight in Britain and internationally.

Is that changing? The case for the prosecution runs like this. Raw material costs are rising, partly as a result of those commodity price rises of last year, partly because of special factors such as the surge in chemical prices, itself in part a result of plant breakdowns in the US. This rise showed through in the UK producer price input figures yesterday, but of course is also hitting industry around the world: we are only seeing the tip of an iceberg.

A further concern is the oil price - the marker that eventually affects all energy prices and is also the key feedstock for many industrial processes. The rise in chemical prices has occurred with the oil price relatively stable - up from the low teens of early last year, but low by middle or late Eighties standards. Now the oil market feels tight. The head of one of the oil giants reckons the underlying supply/demand balance is tighter than at any stage for several years. Put at its most positive, the oil price will not help much in the next 18 months. If you are pessimistic, the price could rise sharply this year.

Those are global issues. Add to these whatever inflation we generate from wage increases (and, among others, Nomura is arguing that our wage inflation is set to rise) and one can construct a decent argument that the good news is over.

There is, fortunately, a case for the defence. It runs like this. There is no gainsaying the rise in commodity prices and the concern over oil prices. The first is a fact and the second an obvious danger. But the market is a powerful self-adjusting mechanism and it may well be that we have already had the worst of the commodity price cycle and, given the potential for the oil market to surprise, we may be worrying too much about that, too. Besides, one dog has not barked. The gold market, historic a llythe market most sensitive to inflationary fears, pushed up last year to $400 an ounce, but has since fallen back.

Wage costs? Well, we will see. There does seem to be a rising premium on skilled labour, but with the entry of new low-wage competitors in white-collar services as well as blue-collar manufacturing, the costs of unskilled labour throughout the developed world seem likely to remain low. (One of the side-effects of the fall of the peso has been to cut Mexican wage costs and so make it an even tougher competitor against the US.)

Capacity restraints? These are occurring, but it is much easier and quicker to increase capacity in a predominantly service economy than a predominantly manufacturing one. There is still, sadly, considerable slack in the labour market in most big developed countries.

Finally there is the discipline of financial markets and the response to that of the policy-makers. Eddie George, Governor of the Bank of England, argued last night that it is possible that the British economy can sustain a higher growth rate than it could in the past before inflation begins to pick up. The very fact that long-term interest rates should have risen by so much last year and the preparedness, in the face of this, of the monetary authorities to increase short-term interest rates, gives a different timbre to this recovery.

In Britain the most evident sign of this change is in the housing market, where prices fell in the fourth quarter and were flat last year. House prices gave a good early warning of general inflation during previous cycles. Why should they not give a goodearly assurance this cycle?

Which case is more convincing? There is little doubt that there will be some increase in inflation through this economic cycle, and there is none at all that the markets will continue to be very worried as this increase feeds through. But the case for the defence suggests that the world's long-term trend in inflation will remain down. There is no reason to suppose that Britain will do worse than other countries. But it does mean the world as a whole faces a year of rising interest rates as policy tightens to meet the threat.