Joker in the global inflation pack

The great debate on inflation continues, spiced every few days by a new element of news. The latest yesterday was the Producer Price Index, which carried two messages. The first was that the upturn in commodity prices was putting pressure on manufacturers' input prices; the second that commercial realities were still holding down the rise in output prices. Both messages need interpretation.

The input side - manufacturers' raw materials - is not that important in overall inflation for two main reasons. One is that raw materials are only a relatively small proportion of manufacturers' costs and a falling one, as the further manufacturers push their products up-market the more value they themselves are adding to those raw materials. The other is that manufactured goods in general are a small and declining proportion of the economy. The key to low inflation is increasingly the ability of the service industries to hold down their costs, and the products of service industries have a very small raw material content.

Nevertheless, at some stage a commodity price boom would threaten world price stability, for the sober commodity prices of the last part of the 1980s and early 1990s have been an important contributor to global price stability. This is not at all a British issue - it is a world one - but nevertheless it would naturally affect us.

So what is happening? The analytical problem is that commodity prices are not homogeneous as the various markets move in different ways: for example, gold has been falling through much of this year, but oil has been rising. As a result, the composite indicators of commodity prices tend to give different signals, depending on the way they are calculated. Thus the Economist index of commodity prices rose from the middle of last year until mid-March, but has since fallen back; but the Kleinwort Benson Commodity Indicator, an index designed to smooth fluctuations in individual commodities, has hardly fallen from its peak.

Given that the global economic cycle has perhaps three years of reasonable growth ahead (with the US slowing but Continental Europe and eventually Japan picking up), this strength in commodities is a little discouraging. Add in the underlying demand for commodities from the newly industrialised countries and one must ask: if prices are rising so early in the cycle, what will happen when growth is more widely established?

My own guess is that the world will have to live with higher commodity prices, including a higher oil price, through the next three or four years and that this will be an important factor fuelling the cyclical upswing in inflation. At its most optimistic, there will be no further benefit to world inflation from cheaper raw materials. At its most pessimistic, rising commodity prices will, through their impact on general inflation, be the main feature behind the next slowdown in the world economy, coming perhaps in 1997.

It is very difficult, however, to see another world commodity boom akin to that of the mid-1970s or early 1980s, because the industrial world is much less dependent on imported raw materials to maintain growth than it was 20 years ago. We use less per unit of output, and we recycle more. So while it is reasonable to see a cyclical upturn in world inflation, it is also reasonable to maintain that the long-term trend remains down.

And the squeeze on prices? The evidence is all anecdotal, but consumers here in Britain do seem to have become price-sensitive. The most striking examples of this is in new car prices and in supermarkets. In both cases there are structural changes in the marketplace that have encouraged price competition. In cars, a number of manufacturers are using keen pricing as a weapon to boost market share now that the company car tax system has been changed. In supermarkets, the arrival of discount stores has forced a change.

The question is how long a policy of squeezing margins to cut prices can be sustained. UK productivity could undoubtedly be improved still further by applying North American and Japanese best practice, and we are going to see much more of that through the whole economic cycle. But as the Bank of England noted last week in its Inflation Report, wage settlements are creeping up and this is not consistent with the use of productivity gains to hold down prices for consumers, rather than reward producers.

Looking ahead, the markets are convinced that all the risk on inflation is on the up-side: they take the view of the Bank of England, simplify it, then exaggerate. There are a few voices on the outer, like Roger Bootle at HSBC Greenwell, who believe the markets will continue to enjoy favourable inflation surprises over the months ahead. If he is right, the case for locking into high-yielding gilts would be powerful indeed.