Retailers feeling the price squeeze

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IS THE Government being too tough on inflation? This week the Bank of England's Monetary Policy Committee cut short-term interest rates by "only" half a percentage point, despite the fact that even the Bank now admits there is some chance of recession next year, albeit a small one.

To cut by more, the Bank of England implied, would be to risk inflation once more climbing back above the official target level of 2.5 per cent. Too little, screamed the British Retail Consortium, which published its own Shop Price Index to demonstrate that high street prices are in fact falling, not rising at all.

There is undoubtedly some truth in these claims - never mind the fact that the BRC seems deliberately to have targeted a shopping basket that puts its members in the best possible light. The prices of food, consumer durables and most utility services are indeed gently declining. To the extent that some product prices are rising - cigarettes and alcohol, for instance - this is largely down to higher taxation.

Even if we accept that the BRC index gives a slanted view, most of us are keenly aware of this relatively new phenomenon - price deflation. The effect of it is all too apparent, not just in falling high street prices, but also in our buying habits. What's the point of buying a new PC for Christmas, when you know it's going to be 10 per cent cheaper in the new year sales?

This cat-and-mouse game between consumer and retailer has been apparent in Christmas shopping patterns for many years now, but this year, with talk of recession in the air and the reality of falling prices, rather than merely the expectation of them, it has reached extreme proportions. Many retailers are predicting their worst Christmas in 20 years.

But it is not just against the BRC yardstick that the Government's Retail Price Index seems to exaggerate the position. Set against European measures of inflation, it also looks out on a limb. Using the European measure - the so-called Harmonised Index of Consumer Prices (HICP) - British prices are rising at just 1.3 per cent a year. This is a little higher than the overall inflation rate for euroland, but it is still well below the 2 per cent ceiling the European Central Bank will be using for inflation targeting purposes.

Why then are our own short-term interest rates still so much higher than the rest of Europe? At 6.25 per cent, even after this week's half-point cut, they are more than double those of our European partners. Just to put that in perspective, the average mortgage holder would be pounds 150 a month better off if our interest rates conformed with those of the rest of Europe. We shouldn't forget the millions of savers who would be worse off in all this, but across the country as a whole, the impact would plainly be considerable.

The answer to the question why lies in our soaraway service sector. The price of the simple bear necessities, from food and energy through to mobile phones, computers and the Internet (this is the late 20th century, you know), are indeed on the wane, but you just try taking a train or taxi, buying a foreign holiday, getting your hair cut, going to a restaurant or hiring a lawyer.

The Office of National Statistics attempts to construct the RPI in a weighted way which reflects what British people actually spend their money on. In theory, therefore, it is a better measure of price inflation than any of the alternatives. Arguably, Europe's HICP understates the real rate of inflation. But if, alternatively, the position is overstated by the RPI, it really doesn't make any difference. If Europe used the RPI, it would presumably have a higher inflation target.

This still doesn't answer the question of why our interest rates are still so much higher. Surely if inflation is about the same, then interest rates should be as well, shouldn't they? In the long term, it is impossible to contest the logic of this argument, but just consider the effect of cutting UK rates down to 3 per cent, or even just 5 per cent, with immediate effect.

Britons are used to living with high inflation and high interest rates. Culturally and structurally, this makes our economic behaviour quite different from that of the Deutschmark economies. Weh hey! would be our response. Just think of it, a mortgage rate of 4 or even 5 per cent!

At a stroke, an average mortgage holder would be able to borrow an extra pounds 30,000 and be no worse off. At the very least, house prices are going to soar. As likely as not, we'll be going out a bit more and jetting off to the winter sun. We might even start getting our hair cut more often.

Whatever we spent our money on, prices and wages would start rising again quite quickly. Within no time at all we'd have a boom on our hands. It all comes down to the old point that the British economy is out of sync with the rest of Europe. We are close to the top of the business cycle going down, they are close to the bottom going up, or at least most of them are. Even though our inflation rates are about the same, it is not yet appropriate for us to have the same interest rates.

How quickly we get to that point depends on the Bank's and the Government's success in exorcising our inflationary traditions. On this score, the signs are already good. Long-term interest rates, as dictated by yields on long bonds, are much closer to European levels than short-term ones - less than 1 percentage point against 3.25 points. Nobody, other than the Government, can yet borrow at these rates, of course, but the benefit of them is already apparent in ever-cheaper fixed-rate mortgage deals.

None of this means that the Bank of England's Monetary Policy Committee is getting it exactly right on interest rates. Prices are behaving in ways we haven't experienced for decades. The Office for National Statistics managed to cock up on the earnings figures; who's to say it's any better on the RPI? And in any case, the RPI is a backward-looking measure.

It may be that the BRC is right to insist that the reality is falling prices. Certainly the expectation of them, coming on top of the fear of recession, is beginning to distort spending behaviour markedly. If this means we are deferring expenditure, that in itself is recessionary.

On the other hand, the MPC is right to resist the pressure for much steeper immediate cuts in interest rates. It would be a terrible thing to undermine our new low-inflation economy just as we seem to be getting it right for a change.