Essentially, the interpretation was that if manufacturers were able all of a sudden to ratchet prices higher then surely this implied that inflation at the consumer level was also set to rise, thereby limiting the MPC’s scope for lowering interest rates.
The problem with this simplistic approach is that it isn’t born out by the facts. Historically, the relationship between inflation at the manufacturing and the consumer level has been extremely loose – a function of the fact that manufacturing comprises less than 15% of GDP. Moreover, what no other commentator appears to have picked up on is that most of January’s acceleration in producer output prices was attributable to a 30% surge in “recovered secondary raw material prices” – essentially scrap metal prices that have been driven higher by strong demand from China. But this accounts for less than 1% of manufacturing. There was therefore never any danger of this feeding through into the January CPI figures, which again surprised on the downside. True, the annual rate of change edged up from 2.1% in December to 2.2%, but this was significantly less than the 2.3-2.4% expected by the consensus.
Given the acceleration in energy and food prices in recent months, this actually represents a good outturn. We don’t deny that the cost of living has risen materially over the course of the past 12 months. But what we would argue is that there has been no follow through into underlying inflationary pressures. Indeed, the annual rate of change in the CPI excluding energy, food, alcohol and tobacco actually moved lower in January, falling from 1.4% in December to 1.3% in January. If anything, therefore, underlying inflationary pressures have fallen over the last few months. This measure of underlying inflation is likely to become the MPC’s key inflation measure during the course of 2008. Regardless of what now happens to headline inflation over the coming months, as long as the underlying rate remains well behaved (thereby demonstrating that higher energy and food prices are not feeding through into more generalised inflation) and economic growth remains sub-trend, the MPC will continue to cut rates. Our forecast for Bank Rate remains 4.25% for the end of 2008.