A food price puzzle for the UK
We all eat food. So we should all be interested in what's happened to British food prices in the past year or so. The members of the Monetary Policy Committee who appeared before the Treasury Select Committee this morning also have what you might call a professional interest in the subject. Along with other commodity prices, rising food prices have been a key piece of the British inflation puzzle that the Bank of England has been getting wrong.
There's a micro issue here, and a macro one. The "micro" puzzle, highlighted by recent research by UBS [160KB PDF], is whether and why UK food prices have been rising more quickly than in other countries. The "macro" puzzle, highlighted by deputy governor Charlie Bean in his answers to MPs, is why British companies - including food retailers - have been able to pass on higher input costs to consumers, despite the subdued state of domestic demand.
On the micro puzzle, these are the highlights of the UBS study:
"Clearly, all economies have had an increase in consumer food prices over the last year - the significant rise in commodity prices has generally offset or more than offset the modest declines in labour costs that have been experienced. The UK does, however, stand out as being somewhat anomalous in experiencing significantly more consumer food price inflation than elsewhere." (see chart below which is on page 7 of report)
"This pattern tends to hold when we break food down into its subcategories.Looking at the broad subcategories of food that are identified by Eurostat, the UK stands out as having the broadest range of food price increases. Politicians may well feel justified in asking 'if everyone faces the same commodity price increases, why does the UK have so much more food inflation?'"
There are some possible answers to that question. One very obvious one would be that the fall in the pound has pushed up food prices faster than in other countries. If you looked at a similar chart for CPI inflation overall, you'd get a similar picture: prices going up faster in the UK.
Is there anything that is happening to food inflation that can't be explained by the weak pound? The UBS researchers think so: they estimate what's actually happened to the cost of retailers' inputs, including import prices (so, taking account of sterling) and changes in industry wages. They then estimate how prices "ought" to have risen, in response to these cost changes, and compare that to what actually happened. The results are shown in this second chart (from page 11 of the report).
Their "killer" conclusion is that the cost of retailer inputs has risen by about 3.5% in the past year, while the average price of processed foods in the shops has risen by 6%. As the authors suggest, that is likely to cause some bother for the supermarkets, and probably renewed calls for politicians to "take action" against the supermarkets. (As ever, what that action might be is less clear).
However, there is another, equally interesting, conclusion to be drawn from this chart - which is that, until recently, there was a remarkably strong correlation between the cost of the inputs and the cost paid by the consumer. UBS says the correlation is 93%. That is what you would expect to see in a competitive market.
If the UBS model of costs is roughly right - and it very rough and ready - then there is a short-term UK food price puzzle, but long-term, retailers seem to have adjusted prices in line with their costs. Indeed, in the early noughties, the chart suggests they were actually raising prices more slowly than cost increases would have justified.
This is about the rate of change in prices. There has been a similar argument, in the past, about the level of UK food prices. In 2000, the Competition Commission found that food prices were 12-16% higher in the UK than in other similar European countries, but the difference could be explained by, among other things, different planning regulations in the UK which pushed up the cost of commercial land.
More recently, Eurostat found a similar price gap. The micro argument over these numbers, and what, if anything, they tell us about UK retailers will run and run. But for the Bank of England, the more urgent puzzle to solve is the macroeconomic one.
As Charlie Bean explained to the MPs on the committee, one of the reasons the Bank has got its inflation forecast wrong was that it underestimated how much "pass-through" there would be from a lower pound (and therefore higher import prices) to higher retail prices. In the 2006 speech that I cited a few weeks ago, he made much of the fact that a sharp rise in energy prices had not then translated into higher inflation. He believed this was due to tougher global competition:
"Exactly the same heightened competitive pressures in product markets that appear to have contributed to the flattening of the inflation/activity trade-off, may also have affected the way that businesses have responded to the increase in energy costs. Rather than immediately pass on in full such increases in higher prices, it appears that they may have instead looked to lower other costs, either by granting lower wage increases, or by putting downward pressure on the prices of intermediate inputs, or by raising efficiency. Our regional agents have also asked a sample of their business contacts how they have responded to the squeeze in profit margins occasioned by the rise in energy costs. The survey suggested that relatively few businesses expected to be able to raise prices and instead planned to raise efficiency, reduce employment or push down on wage and other costs. And some respondents felt they had little alternative but to accept the hit on their margins. That was especially the case in manufacturing, which is the sector that is most exposed to international competition."
British manufacturers are just as subject to global competition now as they were in the mid-noughties. When you consider the subdued state of the economy, you would think they would be even less able to pass on cost increases in 2010 than they were in 2006.
Instead, as the deputy governor noted in his testimony, we have seen the opposite: a higher degree of pass-through than before, and a much worse forecasting record for the Bank of England. That is one of many puzzles about the UK's inflation rate that the Bank now urgently needs to solve.