View from City Road: Comatose inflation points to healthy recovery

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The financial markets have now had several months of unexpectedly good news on retail prices. But, perhaps wisely, they are still not convinced that the Government will stick to its target for underlying inflation in the longer term.

Gilt prices yesterday responded positively to last month's fall in headline inflation to 1.2 per cent. But the gap between conventional and index-linked yields shows that the underlying rate is still expected to be double the Government's 2 per cent target over 10 years and more. The battle for credibility still has to be won.

The next few months are likely to see the headline rate edge upwards, but the acceleration should not prove alarming. The turn of the year may be more problematic, however, as substantial cuts in mortgage rates drop out of the annual comparison between November and January.

Retail prices will also be pushed higher by excise duty increases, with the shifting of the Budget from March to November bringing the bad news forward. Then, in April next year, the imposition of VAT on fuel will also push up the RPI.

In the meantime, core inflationary pressures are likely to be benign. The combination of low pay settlements, a gradual recovery in jobs and rapid growth in output should see unit wage costs drop for some time yet, offsetting the boost to costs from higher import prices. And relatively subdued domestic demand is still persuading many retailers to absorb cost pressures in their profit margins rather than passing them on to their customers.

But there is a limit to how long these influences will last. If recent falls in unemployment are maintained, workers may soon pursue higher wage increases more aggressively. Indeed, it is the Treasury's nightmare scenario that a new norm for pay settlements may become established well above the rate of inflation. Pay will be a key indicator to watch as this autumn's round begins in earnest, for it will do much to settle the debate between inflation optimists and pessimists.

So far, though, the optimists are winning. Inflation is never dead, but it is certainly looking comatose. Nor, pace some City worriers, is the progress on prices inconsistent with recovery. True, clothing and household goods prices registered their largest June falls since the Fifties, which is testament to tough trading in the high street. But a sustainable recovery was always going to be led by investment and exports, and so far that is what the figures are showing.