Much of British management is having to get to grips with an unfamiliar task: how to keep profits rising when prices are static, or even falling.
For Sir James Blyth, chief executive of Boots, low inflation is not a glint in a politician's eye. It is the reality he has been living with for the past three or four years, and he expects it to continue. 'It has been with us for some time,' he says,'and we've set out to try and plan strategies within a low-inflation environment.' The highly competitive high-street market in which Boots operates means that the company, in Blyth's words, 'under-recovers inflation'. In other words, prices rise by less than general inflation. When general inflation is low, this can mean stable or falling prices for Boots.
There is a similar, perhaps more dramatic story, from another retailer at the sharp end of consumer resistance to rising prices. John Clare, chief executive of Dixons, operates within a market where product prices tend to fall from the initial level at which they are introduced to the market. His favourite example is the colour television, which once cost the same as a Mini. But an entry-level colour TV can now be bought for £120, against £7,000 for a Mini. Dixons, for its part, helps the process along by insisting that its suppliers typically operate on the basis of year-on-year price reductions.
Initial scepticism about whether Britain's inflationary leopard had truly changed its spots is now giving way to a general acceptance that things have changed. And even those who subscribe to the cock-up theory of economic policy - which is that when governments have an opportunity to mess things up they generally do so - accept that the scope for politicians to throw away the present low-inflation advantage is limited.
The Bank of England's enhanced role in the policy process has produced a permanent anti-inflationary bias in policy. Wage bargaining behaviour has changed for the better, partly because of the labour market reforms of the 1980s. Credit growth, which reached runaway proportions during the Lawson boom, has come up against the brick wall of corporate and personal sector debt aversion. And consumers, as noted above, are more price-sensitive than for a generation.
But the adjustment to a low-inflation era is far from painless, even for those companies who have lived with it for some time. For Blyth of Boots, it means tough control of costs: 'We're operating on the basis of matching our wage bill to inflation and, as long as our productivity is growing by between 2% and 5% our margin is very well-protected.' For others, it can be more difficult.
Milton Friedman, the father of modern monetarist economics, drew the analogy between inflation and drug or alcohol addiction. At first, he said, the effects can appear pleasant, even benign, but very soon it gets nasty. No one doubts that they would be better off without it.
But inflation, like addiction, becomes a hard habit to kick. Right now, Britain is in the painful, cold-turkey phase of kicking a long-standing habit. Many say it would be far easier to slip back into the habit. The scepticism over Britain's ability to become a stable-price economy is being overcome, but now comes the hard part: rewriting strategies that were developed during an inflationary era.
Michael Portillo, the secretary of state for employment, recently gave a speech, entitled the Challenge of Low Inflation. 'Businesses cannot plan effectively if prices are rising rapidly,' he said. 'They over-compensate for inflation when goods are being priced. As management plays safe, they create upward pressure on prices. Today, British management sees that the only route to growth in long-term profits is to give consumers - here and abroad - what they want at prices they can afford.' The difficulty, Portillo added, was to persuade the public of the virtues of stable prices: 'We face today an extraordinary challenge: how to persuade people of the need to maintain permanently low inflation. It requires a major achievement of statesmanship to convince people that low pay rises which keep their value are better than high ones that do not.'
For politicians, the assumption that businesses find it easy to adjust to low inflation, while for a less enlightened public it may be much harder, is a convenient one to make. Managers, however, are entitled to be as sceptical as anyone about whether we have entered a new golden age of zero inflation, and in many ways have more to lose if the vision of a stable-price British economy turns out to be a mirage. The severity of the recession of the early 1980s was due in part to a clash between businessmen who believed the Thatcher's Government's low-inflation message and workforces which did not, and refused to moderate their wage demands. Then, the return of inflation in the late 1980s produced some undeserving corporate beneficiaries.
'In inflationary times many companies, particularly those with a strong asset-backing, get baled out in the end,' says Doug McWilliams, head of the Centre for Economics and Business Research (CEBR). 'We're now having to get used to something rather different. Asset price inflation will not rescue weak managements.'
McWilliams sees a low-inflation future, but one that is far from painless: 'A lot of people think in terms of low inflation accompanied by very low interest rates and a situation in which all prices are stable. But I see high real interest rates and quite pronounced movements in relative prices. Prices of manufactured goods are likely to be falling even if commodity prices are rising.'
This conundrum is not hard to explain. Increasing industrial output from newly emerging economies such as China and India will drive up the demand, and hence the price, for raw materials. At the same time, because these countries are low-cost manufacturers, their impact on world markets will be to exert downward pressure on the prices of manufactured goods. This provides Lesson One of the low-inflation era, that cost-cutting becomes a way of life. 'Most companies will find that they will have to work as hard to reduce costs during "normal" times as they ever did during the recession,' says McWilliams. 'Not surprisingly, many managers regard this as very unfair.'
Nick Morris, director of the consultancy London Economics, takes this point further: 'Many businessmen, having got used to inflation, find it hard to believe in price elasticities (the fact that demand responds to price changes). If your product isn't selling and we are in a period of no inflation, holding prices is not enough - you have to cut them.' And, because price-cutting has in the past often been regarded as a desperate throw, or as undermining a reputation for quality, it does not come easily.
Pressure from international forces is one factor that is forcing new thinking on companies. But there are others. Roger Bootle, chief economist at HSBC Markets (the money-market arm of the Hong Kong & Shanghai Bank) recently published a paper, The End of the Inflationary Era. In it he described the new psychology of low-inflation among consumers, which is forcing companies to change their pricing behaviour. The landscape could hardly be more different from that prevailing in the 1980s.
'Areas which have discovered the power of price include clothing and footwear outlets, supermarkets, newspapers and insurance,' he says. 'But there are whole swathes which have yet to catch on. If they are in a line of business where demand has seemed inelastic in the past (unresponsive to price changes) they find it difficult to realise that they have become price-uncompetitive in an economy where consumers have become more sensitive to price.' Bootle believes the realisation that this is a new era will come in stages. At first, he says, many firms are reluctant to openly cut prices: 'Instead, they resort to discounts, special offers, tokens, gifts and other forms of disguised price reduction, perhaps because they regard the current 'value sensitivity' in the market as temporary and wish to preserve the image of their posted price as the real price.'
The result of this, he says, is that for some time there have been two price levels in existence - the official price level, which he dubs the fictional price level because very little business is done at it. The other price level, with discounts, special deals and sales packages, is significantly lower and is one at which most business is conducted. Over time, these two price levels will inevitably converge, Bootle predicts.
One example is in the motor trade. Traditionally, retail buyers of new cars were accustomed to regarding the manufacturers' list as a ceiling from which a discount, often a very hefty one, could be negotiated. The real price was well below the official price. In 1993, Vauxhall pioneered a shift towards more realistic list prices by cutting dealer mark-ups. Other manufacturers followed.
But now a second stage of adjustment is in prospect. Retail car buyers continue to face substantially higher prices than company or fleet purchasers (and, for that matter, retail customers elsewhere in Europe). Their response has been to desert the new car market in favour of used cars. New car sales to private customers have been running well below year-ago levels, while company purchases are well up, even though the normal workings of the replacement cycle would suggest a strong recovery in private registrations. The manufacturers thus face a choice between a stagnant or declining private-customer market and further reducing their prices. Indications are that they will opt for the latter.
Professor Garel Rhys, of Cardiff Business School, says that the private buyer will only return to the new car market in numbers if the manufacturers reduce their prices to US-style levels, perhaps to just two-thirds of current prices. For once, on the comparison drawn by Dixons' Clare between car prices and those of consumer electronic products, the gap could start to narrow.
Keen pricing, then, has to be the strategy in a low-inflation era. But that isn't the end of the management process. The fundamental question is how to keep prices stable, or reduce them, and still improve earnings.
Cost control, as the CEBR's McWilliams says, has to be as tough in recovery as in recession. Inevitably, one of the hardest areas in which to achieve this will be with wages. The labour market is subject to what economists call the 'money illusion' where people feel better off if they are getting a 10% pay rise alongside 8% inflation, than if the two figures are 3% and 1% respectively.
Bootle points out that the cards are heavily stacked in favour of management. Widespread job insecurity has curbed labour militancy. 'The new technological revolution is labour-saving. The demand for button-pushers and lever-pullers is substantially reduced. Smaller and smaller numbers are employed in manufacturing. Even in the office, technology has made possible substantial economy in the use of clerks and typists. The structural changes stretch deep into the service sector. In transport, for instance, computerisation greatly reduces the number of people needed to run a railway system. And the potential developments are huge.'
Even the civil service, which is budgeting for substantial staff reductions, can plan on the basis of declining labour costs in real terms. Britain could be on the verge of the pattern produced in America over the past 20 years, where real wages for the average worker have steadily declined ( in contrast to the 2% a year average rise in Britain).
But if these macro factors are helpful, they may not solve the problems facing individual firms. These fall into two categories: the first is how to respond to particular skill shortages, which have emerged even in a weak employment recovery; and the second is how to motivate staff in an era of slow-growing wages.
The two problems are closely related. One of the difficulties of low inflation is that it is harder to establish the differentials needed to retain key staff. In a period of moderately high inflation, the difference between a 10% rise for those who could be poached by other firms, and a pay freeze for others is significant. But when the total wage has to be frozen, it is hard to single out vital staff.
'There has to be less of a focus on the annual pay settlement,' says Robbie Gilbert, director of employment affairs at the Confederation of British Industry. 'Companies have to look at the total labour costs package and this is not easy. Employees tend to undervalue parts of that package - for example, pension arrangements.' Gilbert concedes that there remains a huge educational task in persuading people that small pay settlements which keep their value are better than large ones which do not. Incentives and the problems of skill shortages can, he maintains, be appropriately covered even in a low-inflation environment. 'Motivation is one of the reasons why performance-related pay has to be an important part of the story, including the Government's profit-related pay scheme,' he says.
A low-inflation environment should lend itself to long-term pay deals. In practice, however, both managements and unions have been reluctant to commit themselves to deals stretching for more than two years. Long-term deals have not, so far, worked to the obvious benefit of companies, because in a period where both inflation and pay settlements have come in below expectations, second-year increases have tended to be higher than those that could have been freely negotiated at the time. The combination of long-term deals for basic pay coupled with a substantial profit-related element is now suggesting itself as the way forward.
If the adjustment of long-standing labour markets is one difficult but necessary requirement, another one is financial assessment and control. Should companies set lower hurdle rates of return in an era of virtually stable prices and cheaper borrowing costs? The Bank of England, CBI and Michael Heseltine, President of the Board of Trade, have all weighed in to a greater or lesser extent with suggestions that firms are too conservative in assessing capital projects because hurdle rates of return, typically 20%, are too high.
This, however, is hotly disputed by McWilliams of the CEBR. 'Firms rarely link a low rate of inflation to expectations about returns. Too many people have got hold of the wrong end of the stick on this one. It is legitimate to ask if target real rates of return are too high, but this is not related to expectations about inflation.'
Where the argument may have some point is if companies are so uncertain about the inflation outlook that they build in a premium when setting nominal rates of return to allow for unanticipated inflation shocks. Even here, though, there are factors pushing in the opposite direction, notably that because of a more rapid turnover of technology, and the fact that obsolescence comes sooner in the life of capital equipment, it is perfectly sensible to plan for short payback periods and high real rates of return.
A related issue is that of financial management. Since inflation first became a significant problem in the early 1970s, the accountancy profession has been groping for ways of treating it sensibly. 'We've failed for 15 or 20 years to create a system which adequately copes with inflation,' says Morris of London Economics. 'If this is an era of no inflation, for which our system is still in most respects designed, then perhaps the search can stop.'
Do low prices effectively take over as the main selling-point in the new era, or is there still value in brands? Boots's Blyth has no doubt that brands are a bigger advantage in a stable price era. 'They are a very large advantage,' he says. 'When you've established a reputation for very high quality this works even more to your advantage when prices are not rising.' He cites the fact that Boots successfully saw off a pure cut-price challenge, in perfumes and other products, from Superdrug. Another example is provided by the low-price strategies of Sainsbury, Tesco and Asda, which have meant that the challenge from new discount entrants into the market, including the German retailer Aldi and the club warehouses, has been far less significant than many expected.
In the end, the challenge of low inflation has to be met by good management, which has at its heart the containment of costs and responding to the needs of increasingly price-sensitive but brand-loyal customers. This can be presented as a re-engineering task.
The consultancy, Management Horizons, gives the example of Wal-Mart, the US retailer, which set itself the re-engineering target of delivering 'low prices every day'. This meant reorganising its warehousing and distribution functions to reduce costs and the time that products spend in the distribution chain, including the use of suppliers' warehouses and the replenishment of stocks on a just-in-time basis. Nor, plainly, can such re-engineering be a one-off task. Low inflation means that the search for savings and greater efficiency is an ongoing process.
Companies should benefit from a prolonged period of stable prices. It will not, though, make management's task any easier. In many respects it makes it more challenging.