UK: David smith - Economic truths - With a smile and with a discount - Retailers have been steadily cutting ...

UK: David smith - Economic truths - With a smile and with a discount - Retailers have been steadily cutting ... - David smith - Economic truths - With a smile and with a discount - Retailers have been steadily cutting the price of goods, but interest rat

by DAVID SMITH, Economics Editor of the Sunday Times.
Last Updated: 31 Aug 2010

David smith - Economic truths - With a smile and with a discount - Retailers have been steadily cutting the price of goods, but interest rates will not come down until the services sector follows suit.

Over the years I have noticed a curious phenomenon. Whenever I write about the low level to which inflation has fallen, I am guaranteed at least a couple of letters from people disputing the figures and pointing to all the price increases (usually rent, rates, rail fares, etc) that they have faced.

My stock response is to ask about all the things they did not mention, and to suggest that the prices of those probably did not go up by very much, if at all. Human nature being what it is, people only seem to notice when prices are going up.

Even allowing for this natural myopia, pretty well everybody must have noticed as this year's Christmas shopping gathers momentum that plenty of prices are not going up, and that many are falling. And this phenomenon - an economy where for the next several years it will be normal for the prices of a wide range of goods and services to be falling - will have a profound effect on the business environment.

Many manufacturers will say, of course, that they have lived with this condition for years. Such has been the intensity of competition and the buying power of, for example, the big retailers, that conversations about pricing normally begin with the question: 'How much can you cut compared with last year?'

Such discussions were normally kept from the consumer. What is new is that, for the first time I can remember, genuine price cuts are now happening at retail level. The official retail prices index (RPI), which may not fully capture the extent of discounting, shows that the price of goods (excluding food, petrol, alcohol and tobacco) is currently around 2.5% down on a year ago. Food prices are between 1% and 1.5% lower.

Within this overall drop in the price of goods, there are some spectacular falls. Audio-visual equipment prices, mainly for TVs and videos, have come down by a fifth over the past year. Astonishingly, they are currently less than 45% of their 1987 level. Clothing and footwear prices are down by 3% over 12 months, and between 10% and 15% over the past three years.

CDs, sporting goods and most household durables are lower in price. Second-hand car prices are 5% down. So - thanks to the regulators - are gas and electricity prices. Falling prices are becoming the norm. There are good reasons to expect this to continue. The first set of reasons is industry-specific. The Competition Commission's investigation into the new-car market will finally signal the end of the big discrepancies between UK and European prices. A similar investigation, together with the ntry of Wal-Mart into Britain, will do the same for supermarket prices. In these areas, and others, the current gradual weakening of prices will turn into something more dramatic.

More generally, the pressures of global competition in an environment of low world inflation will have the effect of grinding down prices. DeAnne Julius, the most 'dovish' member of the Bank of England's monetary policy committee, makes the point that you have only to look back into Britain's economic history to see this effect at work. In the 50 years leading up to 1914, the combination of the entry into global markets of countries that were later than Britain to industrialise and rapid technological change produced price falls extending over many years.

But why, if all this is happening, does Britain not already have negative inflation (in other words, generalised deflation), and ultra-low interest rates to match? The latter would at least make falling prices easier to bear.

The answer is straightforward - the government and the services sector.

Where the government has a direct and significant impact on prices through taxation, these tend to rise. Alcohol and tobacco prices have risen by 6% over the past year, petrol prices have gone up by 11%. These items alone account for 14% of the RPI.

In the case of services (35% of the RPI), falling prices are far from the norm. So-called shop services (garage services, cafes and restaurants, cinemas, theatres and so on) are rising by more than 4% a year. Non-shop services (insurance, holidays, bus fares, etc) are rising by over 5%.

These are the areas where consumer demand is strongest.

Can this last? I think not. The Government's claim that it is a champion of the consumer will wear ever thinner if it keeps pushing up the prices over which it has control. As for services, the situation where your cinema ticket keeps rising sharply in price while the cost of video recorders and cassettes keeps falling will, in the end, be unsustainable. Goods prices may be in the lead, but services will surely have to fall into line.

This does not necessarily mean we are heading into a situation where all prices are falling, although it could. The floor for many service-sector prices is probably set by their high labour component and relatively poor productivity growth. It does mean that exceptionally low inflation will, in my view, become institutionalised. Did somebody say they were nostalgic for the days of a bit more inflation?

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