Brief respite for UK consumers next year, before inflationary headwinds bite once again, says ITEM Club report

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London 7 November 2011: 2012 will be a better year for UK consumers, with inflation having peaked and expected to dip below 2% in the next 12 months. However, according to a special report released today by the EY ITEM Club, the respite will be short lived. Once the recovery has taken hold, there is a strong chance that inflation will pick up again, eroding real wages.

Inflationary pressure compounded by weak wage growth
ITEM Club says that inflationary pressures from the VAT rise and global commodity prices will ease next year, helping to stabilise consumers’ finances. However, the report warns that as companies seek to increase profit margins and workers try to restore real wages, these competing demands will put upward pressure on core, or domestically-generated inflation.

Neil Blake, senior economic advisor to the EY ITEM Club comments: “Our analysis suggests the rise in margins will hold back the recovery in real wages. This pressure on the UK’s workforce could last much longer than conventional models of the economy suggest. The good news is that food, oil and petrol prices will all start to come down next year, providing some much needed relief for the hard pressed consumer.

“However, the five year outlook is far less rosy as inflationary pressures begin to bite once again. This will be compounded by weak wage growth. While there is so much spare capacity in the labour market, from rising unemployment and a large number of temporary workers, employees will have limited bargaining power to demand higher wages. Consumers need to enjoy next year’s respite as much as they can.”

2% Inflation target ‘unsustainable’ in medium term
ITEM Club says that rising inflation over the medium term will require a change of tactics. It warns that any attempt to use interest rates as a counter measure would potentially jeopardise the tentative stages of the recovery and is instead calling for a relaxation of the 2% inflation target.

Blake comments: “It will be extremely hard to stick to the 2% inflation target over the next decade. Although we expect the overshoots to be modest, raising interest rates as a counter measure would potentially be disastrous in a low growth economy; there is a strong case for the target to be relaxed.”

Pressure will ease on oil and petrol prices next year
According to the report, oil and petrol prices, which made a significant contribution to inflation over the last 12 months, will start to come down next year as supply chain disruptions from Libya and Hurricane Irene fade. However ITEM Club warns that the strength of demand from the emerging markets, a depreciating pound – expected to reach $1.44 by 2015 - and planned fuel duty increases will prevent a major correction in prices.

The report forecasts that oil prices will bottom out at just over $93 per barrel in early 2012 and that by the end of 2015 the average retail price for a litre of unleaded petrol could reach £1.54. ITEM expects the fuels and lubricants component of the CPI to grow by 5.6% a year between 2011 and 2015 – only slightly lower than the 6.1% average of the past five years.

Blake comments: “By 2013 prices at the pumps will be eating into household finances once again. Demand from the emerging markets will maintain the pressure on inflation, as will the increase in fuel duty on the home front. Although the Chancellor cut fuel duty by 1p a litre in the Budget last year, the postponed annual increase of 3p a litre will come into force in January and it’s going to be followed by another hike in August when indexation is implemented.”

Falling food price inflation will chop £76 off household bills
In the short term, there will be some good news for consumers at the supermarket tills. Early signs suggest that this year’s plantings have gone well, raising hopes that crop prices will begin to stabilise. ITEM expects that food price inflation will slow from 6.4% this year, the equivalent of an average £204 on food bills a year, to 3.7% in 2012 or £128 at the supermarket tills.

However the report says that pressure from a growing population, combined with the ever present possibility of future supply side disruptions, will see UK food price inflation average 3.8% a year until 2015, only slightly lower than the 4.7% experienced over the last five years.

“Food prices are likely to remain very volatile. Even accounting for an increasing population, a bad harvest, or adverse weather conditions could still easily see food prices sky rocket above our expectations”, said Blake.

Commodity prices and globalisation
With growth in commodity prices expected to remain firm, as the effects of globalisation continue to feed through and increasing labour costs in the emerging markers limit the degree to which the UK can continue to benefit from cheaper imported goods, the inflationary environment is likely to change over the medium term.

Blake says: “Such a shift in the inflation outlook would present a dilemma for the authorities. Under the current regime this may imply the need for higher interest rates, with the MPC being forced to suppress domestically-generated inflation to offset pressures from higher import costs. However, this would further depress growth prospects in what is already a low-growth environment.”

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