Falling business costs are a forward-looking indicator of weak consumer price inflation to come. For a period, firms will benefit from falling costs by rebuilding their profit margins. But that cannot last forever – eventually, competition will force them to bring the growth in their prices into line with the growth in their costs. We see that story playing out over the coming year or two, with low costs bringing down consumer price inflation gradually to the target of 2 per cent, and below.

 

Consumer price inflation has risen sharply in recent months. The January reading was 3.5 per cent, triggering a letter from the Bank of England Governor to the Chancellor of the Exchequer. This 3.5 per cent figure was affected by the reversal of the December 2008 cut in the rate of VAT, and this will continue to boost CPI inflation until the end of 2010. Once the temporary VAT cut and sterling effects have washed out, CPI inflation should drop back towards the 2 per cent target.

 

The February BPI implies that cost pressures on businesses continue to ease. The main contributor has been lower borrowing costs – we estimate that firms’ cost of finance has fallen almost 20 per cent over the past year, reflecting a combination of lower bank borrowing costs, tighter spreads on corporate debt, and a rise in equity prices. Variable cost inflation remains positive, and has picked up in recent months, reflecting increases in oil and other commodity prices. The contribution from labour costs, however, has started to ease. Whole-economy earnings growth is close to 1 per cent. In the private sector, it has turned negative year-on-year. Put together with the fact that productivity growth is now positive – with employment continuing to fall, but output now rising again – unit wage costs are very subdued.