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Sunday, 18 September 2011

UK Inflation Figures Make A Mockery Of The Economic Assumptions Of Old

News emerged last week that during August, UK inflation went up. Again. The consumer price index (CPI) index last month showed that prices were 4.5pc higher than the same month in 2010.

It is noteworthy, also, that UK construction orders plunged 16pc during the second quarter – to their lowest level since 1980. So the outlook for construction is now worse, even, than during the "credit crunch" proper.

Given the growing sense that a tumultuous "euro-quake" end-game may soon be upon us, or at least the still traumatic acknowledgement of an explicit Greek default, the newsflow from Europe last week was almost overwhelming. So there was, perhaps, less comment than there should have been on the fact that UK inflation had just equalled its three-year high.

It used to be reasonable to assume that when the economy slowed, and unemployment rose, then inflation was likely to fall. Well, the UK has just endured its worst recession in more than 60 years. The economy shrank, peak to trough, by more than 6pc. Despite this historic drop, growth has failed to bounce back, remaining as low as 0.2pc during the second quarter.

Yet still, price pressures have been rising. Not so long ago, the publication of data showing that CPI inflation had overshot the Bank of England's 2pc target by more than 1 percentage point would have dominated the news agenda. The Bank's resulting public letter to the Chancellor, triggered by the 3pc breach and designed to explain the divergence, would have been forensically analysed by the commentariat. Such letters are now so common that hardly anyone reads them.

Over the past three years, monthly CPI growth has averaged – yes, averaged – 3.3pc. Those of us who've raised objections, pointing out that this might become a problem, have been dubbed "inflation nutters". It's as if the British economics profession has contracted collective amnesia, immune to the lessons of history, failing to highlight the danger that inflation in the 4pc to 5pc range can very quickly spiral out of control, as high and self-fulfilling inflation expectations become entrenched.

The UK's economic outlook weakened markedly in August. Survey data suggest the risk of the British economy re-entering recession, the dreaded "double-dip", has grown considerably. All three of the main CIPS survey measures fell last month, the main services index dropping at its fastest rate for 10 years.

It is noteworthy, also, that UK construction orders plunged 16pc during the second quarter – to their lowest level since 1980. So the outlook for construction is now worse, even, than during the "credit crunch" proper. This matters not only because the sector accounts for a chunky 7pc of the UK economy and employs millions of people. Construction is also a reliable "bellwether", with trends in the industry often pointing to what the economic future holds.

It looks likely, then, that we'll see virtually no growth in Britain for the rest of this year, even if global financial markets avoid meltdown.

It's also likely, though, that inflation will keep rising from 4.5pc over the coming months, above 5pc and beyond. The old retail prices index (RPI), more realistic than the CPI that replaced it, is already at 5.2pc. Such inflation numbers, amid a ghastly slowdown, make of mockery of the usual economic assumptions.

A big reason still higher UK inflation looks inevitable in the coming months is the price of energy and other commodities. Utility bills are soaring, as are UK food prices – which rose 6.2pc during the year to August. These miserable outcomes have their origins in the fact that global energy prices, to the surprise of many, have remained remarkably firm despite the latest Western slowdown. As such, another economic assumption of old has been upended.

Until recently, a slump in the "advanced countries", most of which are oil importers, was enough to generate a fall – expected, actual or both – in world oil prices, due to the impact of weaker Western energy demand. This was very useful for the developed world because the lower oil prices that resulted when our economies slowed helped to bring about our recovery. Cheaper fuel and heat would cut household and industry costs, boosting disposable incomes, profits and growth itself. Lower oil prices also helped tame inflation, giving our central banks the room to cut rates, so consolidating recovery.

Global oil markets, then, have long provided a crucial "self-correction" mechanism for the Western world. In light of the cardinal importance weaker crude prices have played in bringing about previous Western recoveries, it's worth examining their recent path.

Last month, amid fears relating to Europe's banks and Western sovereign debts, financial markets obviously took a big hit. The S&P 500 index of US stocks gave up all its 2011 gains, ending August 4pc down since the start of the year. Analysts slashed their growth forecasts for the US, the UK and mainland Europe. Yet, incredibly, the price of oil, while it has oscillated, has stayed pretty much where it was. Brent Crude remains up more than 21pc since the start of 2011, averaging no less than $112 (£71)/barrel so far this year.

Why is this happening? Typically, signs that the West is slowing, on cue, bring oil prices down too. But the markets now judge that the fundamentals suggest crude prices should stay roughly where they are, even if the West is struggling, not least because the bulk of oil demand in the world now derives from elsewhere.

The non-Western world today accounts for 55pc of global oil use. The insatiable energy appetite of China, India and the other large emerging economies – most of which are still growing by pc to 8pc – means they now set the tone on world commodity markets. The numbers are truly incredible.

The US Energy Information Agency (EIA )has just released estimates that the world will use 88.2m barrels of oil daily during 2011 – an all-time high, despite sluggish Western growth. As the emerging markets have expanded, engaging in massive infrastructure building, while their huge populations have become richer and adopted more energy-intensive lifestyles, global oil use has risen no less than 15pc over the past 10 years.

The EIA forecasts oil demand of 99m barrels daily by 2015, another 15pc rise from today, but this time in five years. Even in 2009, when the world economy contracted, world oil demand fell just 2pc, then grew 4pc the following year. So the oil market's long-held assumption of "demand destruction" when Europe or America slumps, is now being seriously tested.

The supply-side of the oil market also looks tight. The credit-crunch cut investment in exploration and well-development. The EIA sees a short-term deficit of 1.4m barrels per day in the fourth quarter of this year. Looking forward, oil traders are now showing a lot more interest in rapid depletion and falling yields at Ghawar, Cantarell and the world's other giants fields.

The politics of Opec have also recently been turned upside-down. Just a few years ago, Saudi Arabia made sure the exporters' cartel targeted $25 a barrel, so as to keep the Western world buoyant and oil demand strong. But now the Middle East can sell crude, as fast as it can pump it, to the emerging giants of the East. Meanwhile, the "Arab Spring", and resulting social expenditures to placate restive populations, mean that Saudi, and other oil exporters in the Gulf, need oil above $100 just to balance their budgets.

Like so much in economics these days, our usual assumptions about the oil market, in place for decades and reassuring for the West, are being revised before our eyes. The implications of these revisions we'll ultimately find impossible to ignore, even if so many continue to dismiss the inflationary dangers we face.

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