A return to inflation? - by Mark Oliver

A return to inflation? - by Mark Oliver

The priority of economic policy in the UK for decades has been a focus on keeping the inflation rate under control.   The most recent inflation figures (February 2012) point to a falling rate, although still well above the Bank of England target of 2%.

However, as we are all aware, inflationary pressures vary widely between industry sectors.  It could be argued that UK rate has been kept artificially low for the last twenty years by an increasing trend to outsource manufacturing to emerging markets where costs are significantly lower.   For manufacturing sectors still based in the UK (and particularly for building products where outsourcing manufacture is not an option due to the transport costs), a rising cost base combined with pricing pressure from buyers is leading to a situation of pent-up inflation in product costs that could provide some nasty surprises.

Clearly the building industry is going through an extremely difficult period.   Many product manufacturers are in the unenviable position of providing what are perceived to be commodity goods in a market which has seen significant over capacity.   It has been a buyers market and in this environment, price pressure on manufacturers is heavy.

All industries adapt to changing market conditions, and, as manufacturing capacity is reduced, so prices stabilise. I would say that we have reached this point now for most categories of building materials.

We are now looking at a market for housebuilding that is marginally more positive.   Builders are able to sell what they build (albeit that the number of builds is still very low compared to the 2007 peak) and prices for new houses are holding up.  Consequently, the results announced by most of the major housebuilders are better, with improved margins and better overall profitability.

However, the manufacturing industry supporting this sector is facing huge pressure from rising costs.    A big percentage of the cost is tied to energy costs.  There has been widespread reporting in the media that retail gas prices have fallen over recent months, with most of the top energy companies passing savings of up to 5% on to consumers.  However, this 5% drop needs to be put into context with the 15% rise over the previous year.

There is also a context of a rising green tax burden where the laudable aim of controlling carbon emissions also increases costs for manufacturers.  Combine this with the steadily rising prices for raw materials and the net result is a pent-up inflation that has so far not been passed on through the supply chain.

Manufacturers are realists and expect, where possible,  to absorb costs in a downturn. Reducing manufacturing capacity, cutting back on investment and putting new product development on hold are all ways of achieving this in the short term.  However, I would emphasise the phrase short term as none of these actions can be continued indefinitely without causing structural damage to individual businesses.

In my view we face a choice.  The better option is for prices to start to rise gradually, allowing manufacturers to ease up on their austerity measures and get back to developing ever better products without producing sudden and dramatic price rises that could be very destabilising.

Alternatively, if there is no room for a gradual increase, then the pressure faced by manufacturers will start to see the weaker companies going under.  This would solve any short-term over-capacity problems, but then those left in the market will be able to demand premium prices as shortages develop.  When demand returns, which one day it will, the capacity won’t be there and prices could rise even higher.

In the long term we also need to consider where the UK sits within a global market.  If multi-national manufacturers start to consider that the UK does not offer them any realistic prospect of decent profit, then why would they choose to invest in manufacturing capacity here?  We are already hearing rumours of this type of discussion and it would be hugely damaging to the future of UK construction if we were excluded from international investment.

What we need is for merchants and manufacturers to work together, recognising our interdependence and acknowledging that rising costs cannot be ignored for ever.    Without this acknowledgement the scene is set for a tumultuous period of price instability just at the point where the industry finally emerges from recession.

Website by ib3