Outside Edge: Of turtle doves and inflation hawks

8th January, 2011

The UK’s coalition put up value added tax by 2.5 percentage points last week, guaranteeing a day of bad headlines about rising prices. But anyone buying products dependent on the price of oil, or gold, or copper, or wheat, doesn’t need George Osborne to experience a world of sharp increases in prices.

Even Christmas was more expensive. According to PNC, an American company which calculates these things, the cost of buying the items mentioned in The Twelve Days of Christmas rose by a painful 9.2 per cent last year.

Doubtless inflation doves would point out that this was caused by a punitive jump in the price of major “non-core” components in the indicators, including lords-a-leaping, swans and gold rings.

I don’t buy this for a second: it’s all very well for central bankers to split hairs over core and non-core inflation. But if your true love wants nine ladies dancing, the price increase of 15 per cent is very real. And if you are feeding a family of five in Dhaka, Mexico City or Casablanca, the increase in the price of food is more real yet.

Yet for those of us not living hand to mouth, there is something rather bracing about sharp price rises. Consider petrol, which follows a “rocket and feather” trajectory. Prices shoot up at the hint of an increase in the price of crude oil, but fall back at the gentlest of rates, long after crude prices themselves have subsided.

There’s no mystery about the “rocket”: in a competitive market, wholesale price increases will be passed through to consumers promptly. But the “feather” is more ticklish, because the same argument should work in reverse, and so wholesale price falls ought to be passed on just as quickly. That means that markets are less competitive when prices are falling than when they are rising – a rather baffling suggestion.

A plausible explanation comes from Matthew Lewis, an economist at Ohio State University: falling prices make us complacent, while rises bring out the bargain hunter inside us, even when there are no bargains to be had.

As long as the price of a product is a little lower today than yesterday, we relax. We assume there’s no need to shop around. Retailers then take their sweet time cutting prices, knowing that we consumers are immensely relaxed, addled by the fact that at least prices are moving in the right direction. Paradoxically, their profits may be higher when prices are falling than when they are rising.

Falling prices may do odd things to consumers’ judgment. The price of computers and clothes has fallen for years, which may explain our otherwise inexplicable love for iPads and bumster jeans. But while the current rising prices will sting, by golly, they’ll keep us sharp. It’s just a shame that we won’t stay sharp when they start to drift down.

The writer would like to clarify that his true love has had no dalliance with any lords-a-leaping.

Also published at ft.com.

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