Lessons from Butter Inflation

by George Hatjoullis

Just before the June 2016 referendum I bought a brick of British unsalted butter from Tesco for 89p. In November I paid 98p. Yesterday I paid 109p. This is 22.5% inflation. The pack proudly states that it is made 100% from British milk. Looking at UK farmgate milk prices I see that they bottomed in June 2016 and have risen by over 30% since that month. This explains the butter price but begs the question of why milk prices have risen. These are not the only price rises that I have noticed. Tesco unsalted nuts were selling for 169p a pack as recently as last week and yesterday cost 200p. This is 18.3% more. Petrol prices jumped by 10p a litre at my local Tesco outlet. Deflation appears to be over, at least for Tesco shoppers.

There are probably two forces at work here. The main force is the depreciation of sterling. It is not immediately obvious why UK milk produced by UK cows eating UK grass should now be more expensive. In part, it may be that the cows do not only eat grass but other feed also which is imported. This is unlikely to explain the magnitude of the milk price increase. It is more likely to reflect a substitution effect. Imported milk is more expensive so demand for UK milk rises, supply does not, and UK milk prices rise proportionately. Unfortunately sterling has only depreciated by around 10% against the euro since June 2016 so it still needs some explaining.

My suspicion is that supermarkets are restoring margins under the shroud of sterling depreciation. Intense competition has seen food retail margins come under pressure and this has hit retailer profits. The retailers will take any opportunity to restore margins and it may be that they are doing so. Consumers are vaguely expecting price increases because of the sterling fall so the reaction may not initially be too severe. However, higher food and energy prices means less to spend elsewhere unless savings contract or incomes increase in proportion. The potential impact on wages is particularly interesting.

The imposition of immigration controls in the UK now seems inevitable. There is no mandate for leaving the EU but there is a mandate to restrict immigration. Even 58% of LibDem voters appear to hold this view. The difference is that not everyone is willing to pay the price of leaving the EU just to impose immigration controls on EU citizens. The referendum was about who is willing to pay this price. Hence I conclude immigration restrictions on EU citizens will emerge one way or the other (I do not approve. I am just stating what I think will happen). For UK employers this presents a dilemma. In the short-term this may lead to labour hoarding.  It is clear from the labour statistics that EU migrants are not displacing British Citizens in the labour market but rather are filling necessary jobs. If they may not be available, and new supplies may be restricted,employers are going to be reluctant to let people go. This will put some additional upward pressure on wage rates. In the long run, the path of wages will depend as much on automation and the final structure of migration controls, but in short-term the effect of controls is to boost wages.

There are some significant labour market and product market inflation impulses. In part they originate from a one-off sterling decline but it does seem that this impulse is being amplified and not damped. Inflation down the line is a prospect and potential problem and the deflation risk seems to have faded for the moment. Inflation may be the variable to watch in the UK in 2017, once again.