View from City Road: Factory gate inflation bodes ill for rate cuts

Yesterday's figures for factory gate prices show another gentle nudge upwards. It is nothing dramatic, but the annual rate is nevertheless 4 per cent against 3.8 per cent in April and 3.3 per cent as recently as November. Although this still represents a modest impact from such a substantial devaluation, it would be surprising if the new Chancellor was to announce an interest rate cut. After all, the Government's target ceiling for underlying retail inflation (excluding mortgage rates) is 4 per cent.

To steer within target, factory gate inflation should normally be a little lower than the target so that services inflation can be higher (as it tends to be, since there is less opportunity to save costs through automation). Instead, factory gate inflation is running with no room to spare.

It is only a small consolation that food, drink and tobacco prices are leading the charge. Part of the rise is due to the increased cost of fuel and raw materials following our exit from the exchange rate mechanism in September. The pound is down by 12.7 per cent since Black Wednesday, and input costs are up by 8.6 per cent.

This ought to have been offset by the continued collapse in labour costs, down by 2.9 per cent over the year to the first quarter, the sharpest drop since 1970.

Taking both elements into account, overall manufacturers' costs are probably still flat. So the factory gate price figures give us the second piece of evidence in a week - the first came in the trade figures - that manufacturers are rebuilding their margins rather than trying to squeeze more volume out of their markets.

Though the figures are not out of line with the economics consensus - underlying inflation is still heading sideways and is likely to end the year at around 3.7 per cent - they do raise the issue of whether the Government has any more leeway to accept one-off price shocks. If another devaluation is needed to staunch the payments deficit, or if further rises in excises and duties are needed to reduce the budget deficit, the Government's 4 per cent ceiling is going to look perilously tight. There are various ways in which the new Chancellor could soften the target, perhaps by removing one-off price rises. For the markets, this is a key area to watch in tonight's 'Mansion House' speech.