Is inflation creeping its way back into the outlook for Britain's economy? Recent events aren't reassuring.
Although retail prices are well-behaved, prices paid by factories for raw materials surged in May, raising fears that wholesale and retail prices will accelerate. Also, first-quarter wages rose faster, as did unit-labor costs.
In addition, the strong showing by Britain's Labor Party in the European Parliament elections--and the expected thrashing received by Prime Minister John Major's Conservative Party--further heightened inflation fears in the financial markets. The new worry is that Major's government is too weak to control inflation should interest-rate hikes prove necessary.
However, inflation fears seem overdone. Despite the 0.9% jump in May input prices, prices of goods leaving the factory are up only 2% over the year, the smallest rise since 1986. Still flush with idle capacity, companies can't pass along higher costs, thus sapping profits.
Retailers are meeting stiff price resistance from consumers facing higher taxes and modest income growth. Annual retail inflation held steady at 2.6% in May. Although the underlying rate--excluding mortgage costs--picked up only a bit, to 2.5% from the record low of 2.3% in April. The real key, though, is wages, since they account for much more of a company's costs than raw materials do. The latest news is encouraging. After a one-time boost from bonuses and overtime lifted the underlying pace of average earnings in the first quarter to 4%, earnings growth slipped to 3.75% in April (chart). The growth rate of April unit-labor costs slowed as well, to 1.9% from 2.2%.
Chancellor of the Exchequer Kenneth Clarke talked tough on inflation and fiscal responsibility in his June 15 Mansion House address. However, slower earnings growth and its calming effect on the financial markets ease pressure on the Chancellor to bend to the Bank of England's hard line on inflation. Even the Bank's Governor Eddie George said at the same venue that higher interest rates are "still some way off."
But given the crucial role of wages, the European election results also raise a long-term inflation worry. The Labor Party showed enough muscle to suggest that it could win the next general election. The fear: A Labor victory could undo the inflation progress made under the Tories.