Inflation shock at factory gates

Factory gate inflation hit a four-year high in July and the annual rate of increase in costs paid by manufacturers for fuel and raw materials remained in double figures.

The figures, much worse than expected, revived fears that the Bank of England will get its way on higher interest rates, particularly if Thursday's release of retail price inflation shows a further jump.

The news hit bond and equity markets, with the September gilt future closing over a point down and the FT-SE 100 index ending 26 points off at 3,441.4.

The revelation of the scale and persistence of cost pressures in the manufacturing sector led to a hasty reappraisal of prospects for interest rates. The short sterling future, used to speculate on interest rate changes, ended the day indicating a rate of 7.09 per cent in December compared with its Friday close of 6.92 per cent.

Geoffrey Dicks, UK economist at NatWest Markets, said that the numbers offered no comfort for retail prices in the coming months. The market consensus is that the headline rate will rise to 3.7 per cent and the underlying rate, which is targeted by the Government, will increase to 3 per cent.

Factory gate inflation increased from 4.2 to 4.5 per cent, the highest since July 1991 and more than double its low of 1.9 per cent a year ago. Inflation in the pulp, paper and paper products industries led the way, increasing by no less than 21 per cent over the year.

The core rate, which excludes food, beverages, tobacco and petroleum products, rose to 5 per cent, its highest since May 1991. Worse still, the rise in the latest three months over the previous three was equivalent to an annual rate of 5.3 per cent - up from 4.9 per cent.

Core output prices rose by 0.4 per cent in July, and June's figure was revised up to a similar rate, one that manufacturers have now been able to push through every month since March. There was no better news on the costs of raw materials and fuels facing manufacturers. Input price inflation which had been expected to fall to about 9 per cent came in at 10.3 per cent. This was partly because of a higher than anticipated month on month rate at 0.5 per cent and also because of upward revisions to previous estimates for May and June.

The fall in commodity prices in recent prices was offset by sterling's slide earlier in the year. Crude oil prices dropped sharply but imported materials, particularly paper and paperboard cost more.

Despite the setback, the City is still confident that the pressure from rising input prices should ease soon. Roger Bootle, chief economist at HSBC Markets, said: "We still feel there ought to be a sharp drop over the next few months."

However, the persistence of high input price inflation, which has now disappointed for at least two months, suggests that the pressure on retail prices from higher prices charged by manufacturers will not ease rapidly. Ciarn Barr, UK economist at Deutsche Morgan Grenfell, commented that although output price inflation was probably at its peak, a sharp decline is most unlikely.

This view was echoed by Kevin Darlington of ABN Amro who predicted that output price inflation would continue to run at 4-5 per cent. While input prices - which account for a quarter of manufacturers' costs - might be past their peak, unit wage inflation - accounting for a half of costs - was now rising. The overall position in manufacturing was unlikely to ease sharply and these pressures would continue to be passed through to the retail sector.

Attention now switches to Thursday's release of the July retail price figures. Even before yesterday's producer price figures, the market was expecting higher rates both of headline and underlying inflation.

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