Business without the balm of inflation

The picture of low-inflation growth - and why it is qualitatively different from high-inflation growth - is gradually unfolding. We are seeing, in both the figures and the gut feel of retailers on the high street, how consumers have become vastly more sensitive to price increases. Thus it was price-cutting that led to strong July sales, while in particular industries, including newspapers, a step change in the pricing of the product has generated a surge in sales.

There has been much discussion about the psychological reasons for the change of mood among consumers. My own view is that the fact that prices are as likely to come down in the future as to go up has caused a radical change in the balance of power between buyer and seller: the former is under no pressure to hurry to buy, while the latter cannot use 'inflation' or 'rising costs' as an excuse to justify price rises.

There has been much less debate about the nature of change in the whole economy that will stem from the prospect of a long period of stable, or even falling, prices. People would become richer, not because they received higher nominal wages or pensions, but because prices were falling.

The markets do not yet accept that this is a possibility, or they would not require yields of 8 per cent on gilts. But any sensible company would be wise to consider the possibility that the unit price for the goods it is making or selling might be lower in money terms in 10 years' time than it is now, and have a contingency plan for such an outcome.

This is what is already happening in Japan: an economic recovery is taking place in consumption in the sense that the volume of sales is rising. But because prices are falling faster, the nominal value of sales is falling. Consumers are getting a better deal, but for companies the effect on both cash flow and profitability is serious. So they have to adapt.

The scale of the price cuts in Japan is dramatic. Sales of televisions during the first five months of this year were up 19 per cent in unit terms. But in value terms, sales were down 3.2 per cent. The reason is an 89 per cent surge in imported TVs, which are sold on average at one-third the price of domestic models.

These cheap imports have an obvious direct impact in cutting the average price that a TV retailer is selling stock; but they also force domestic producers, distributors and retailers to cut their margins.

Manufacturers have responded in three main ways. They have passed the cost burden on to smaller sub- contractors; they have switched production to lower-cost production centres abroad and they have cut nominal wages. The first two options are self-evidently not open to smaller companies, which have accordingly had to squeeze wages hardest. It is their workers who, unsurprisingly, are rushing to buy cheaper imported goods.

Among the large companies, the strategy of Honda is most interesting. Quite aside from the rethinking of its UK strategy after the Rover takeover by BMW, it plans to increase production in the US and Canada by 30 per cent, with the additional production shifting into exports. Last year it exported 45,000 cars from North America, and imported 300,000. It plans by 1999 to increase exports to 150,000 and cut imports also to 150,000. In other words its balance of trade in the US car market will be neutral.

This has inevitable consequences for employment in Japan. Honda is only just starting to consider this, for up to now it has maintained that preserving jobs in Japan is its prime objective.

Compare this Japanese experience with the UK and two things stand out. One is that much of the production of UK companies has already been shifted abroad. The surge in overseas investment by British companies during the 1980s was criticised at the time as exporting jobs, but it is possible to see this as a strength rather than a weakness.

The other is that, with devaluation, exports from the UK are extremely profitable: some figures last week suggested that they are more profitable than at any stage during the past 20 years. The Japanese have an overvalued currency; we have an undervalued one.

However, if the position is very different for manufacturers, particularly in the export market, the same is not true for distributors and retailers. They may well have to contemplate a period where, as in Japan, volumes will rise but turnover will fall. That suggests a much more severe squeeze on margins than the market, at least, is bargaining for.

Companies in the distribution chain, or companies in areas that are by their nature purely domestic markets (including newspapers), must contemplate the possibility of a long period, maybe several years, where their nominal turnover will not increase. Any rise in volumes will be offset by falls in prices. They will have to cut costs by combing every area of their activities, but without the balm of a little inflation to ease the pain.