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Tight profit margins fuel fears of inflation

One of the great unknowns in forecasting inflation over the next few years is what will happen to the gap between the increase in prices manufacturers pay for materials and labour and the prices retailers pass on to customers.

According to the Bank of England's quarterly Inflation Report, released yesterday, this gap has yawned wide open during the past two years because of the dual nature of the recovery: the sunny fortunes of sectors involved in international trade and the clouds overhanging the UK economy.

While manufacturers have faced steep increases in their costs because of higher commodity prices, the fall in sterling and leap in import prices, retailers have not been able to pass higher prices on because of weak demand. Somewhere in the middle profit margins have been squeezed. They have probably now been squeezed as much as possible. Materials costs have been rising at double-digit rates since late last year, accompanied by only a gentle upward drift in retail prices.

Some details of precisely what is happening along the inflation pipeline were set out in the Inflation Report and have also been charted in a recent paper by City economists at UBS. According to the Bank of England, labour costs per unit of output account for about half of manufacturers' costs; materials and fuels a quarter, imports of finished manufactures a tenth, and services the rest. The total import content of non-labour costs is nearly 45 per cent. Unit wage costs fell throughout 1994 and rose in the first quarter of this year.

The most intense pressure, however, has come from materials and fuels, whose costs rose 11.3 per cent in the year to the second quarter and contributed 2.5 percentage points to a 3.6 per cent increase in unit costs excluding labour. The next biggest contribution came from prices of imported finished manufactures. By contrast, the cost of bought-in services was flat in the 12 months to June.

The impact has been to take growth in total costs in manufacturing up to about 5 per cent year-on-year, in marked contrast to the early part of last year, when costs fell slightly.

The rise in industrial costs has led manufacturers to increase prices at the factory gate, but at a slower rate, putting pressure on margins. In the year to June factory-gate prices were up 4.2 per cent. Excluding volatile food, drink, tobacco and petroleum products, underlying prices increased 4.8 per cent, the highest in more than four years. However, the rises have been showing signs of moderating

The pressure on margins further down the distribution chain has generally been more intense. Retail price inflation has risen from a trough of 2.2 per cent last September to 3.5 per cent in June. During the same months producer output price inflation has climbed from 2.3 per cent to 4.2 per cent, and up from 2.1 per cent to 4.8 per cent on the underlying measure.

According to the UBS study, distributors' margins, which soared during the 1980s, have fallen from their 1990 peak. The data indicates the fall has been modest, although distribution includes hotels, restaurants and wholesalers as well as retailers. For retailers alone the squeeze on profit margins has been more severe. The Bank of England puts the rise in retail costs in the year to the first quarter at 4 per cent, with a 1.9 per cent increase in underlying prices.

The downward trend in retail margins has lasted now for two and a half years. How much longer can margins fall, both in industry and on the high street? There are signs it is ending. Verdict, the retail researchers, reported earlier this week that the big supermarket chains have been rebuilding their margins during the past three months.

The stores have passed on more of the inflationary pressure to their customers, opting for loyalty schemes rather than price competition.

The Inflation Report concludes: ''Firms may try to restore domestic margins by increasing prices instead of bearing down harder on costs.'' Mervyn King, the Bank of England's chief economist, says it would not be surprised to see a cyclical recovery in margins.

The danger in this is that it removes a safety valve for containing the inflationary impulse of higher commodity prices and the weak exchange rate. There were no subsequent second-round effects from the pound's fall in 1992 because profit margins were at a peak and had plenty of room to fall. According to Mr King, the fact margins have been squeezed as much as they can ''must increase the risk of second-round effects on prices and wages''. That would mean higher inflation in the short run, and over the longer term too if monetary policy were not tightened sufficiently.

Profit margins are not the only influence on inflation. But they are important because the end of the profit squeeze on retailers and manufacturers selling to the home market means the Bank and the Chancellor of the Exchequer cannot dismiss price increases along the inflation pipeline as a one-off effect of the weak pound. This is not 1992. There is a risk this time that imported price rises will metamorphose into a classic British inflation cycle.