Thanks to rising inflation, many private sector companies are being forced to settle pay deals at levels that threaten the government’s inflation targets, because of clauses in long-term pay deals.

Only last week Shell tanker drivers agreed to a 14 percent two-year settlement with managers, which has prompted fears this would set a precedent for other workers and calls for restraint from ministers.

Research group IDS Pay Databank’s analysis shows many other companies which previously negotiated two or three-year pay deals – at a time when inflation was expected to stay low for years – are having to give their workers a wage “kicker”.

This is because a large portion of such deals are linked to the Retail Price Index, which has risen sharply in recent months to 4.3 percent.

Such agreements are set to undermine the Alistair Darling’s pleading. Speaking to the BBC on Sunday, the chancellor said that “Pay awards in both the public and private sectors have got to be consistent with our inflation target of 2 per cent.”

Mr Darling and John Hutton, the business secretary, argued last week that the tanker driver’s settlement was a one off. However, other recent deals include Drax Power, who agreed a 7 percent pay rise for 60 workers, forming the second of a two-year deal. Babcock Engineering recently agreed a 7.6 percent increase with 50 workers.

Barclays Bank has implemented a 5 percent pay increase for 55,000 workers, as the first stage of a three-year RPI-linked deal.

These deals are much higher than the 3.3 percent Consumer Price Index measure of inflation. The government has tried to keep public sector deals at about 2 percent.

David Frost, president of the British Chambers of Commerce, described the trend as a self-fulfilling scenario which would fuel inflation further.

IDS has indicated the highest pay awards in three months to April – the last month for which accurate figures exist – were made to companies in energy and water, chemicals and engineering. One in five deals over 4 percent were lined to RPI.

Lois Wiggins, a researcher at IDS said: “The main reason they are now settling so high is because many are part of long-term deals, which means that in the second or third stage of these deals RPI is being used to work out the settlement.”

The most recent report by the research group, which showed wage inflation of 3.8 percent, suggested employers had been “wrong-footed” by predictions inflation would remain subdued.

This will add further pressure on the government as it seeks to keep a hold on wage inflation. Several unions have openly defied this policy in recent days, with Unison threatening to re-open a key NHS agreement for 500,000 employees.

Alistair Darling and Mervyn King yesterday delivered a bleak assessment of economic prospects for 15 years in what the Bank of England governor said was “the most challenging period” since 1997.

Mr King, during his annual Mansion House speech to City grandees, warned households should prepare for the “average take-home pay [to] stagnate this year”, and said that “the squeeze on real income growth is likely to mean that both house prices and consumer spending weaken together”.

In addition to this, the chancellor conceded his Budget forecasts would not be met, accepting that inflation would be higher than predicted and that no country could escape the effects of higher inflation on real incomes and economic growth.

Both Mr Darling and Mr King stressed the need for wage restraint. The chancellor insisted “inflationary pay settlements would undermine rather than raise people’s living standards” and the Bank governor waned that an economic slowdown “will be necessary to dampen price and wage pressures”.

The Shell tanker driver wage dispute is just one example that some companies and employees will do what is best for them rather than for the wider economy. The government insisted that the drivers 14 percent over two years, pay deal was “particular” to the industry, but Mr King issued a warning that he would not allow higher pay deals to result in ingrained inflation.

In a sign that the Bank of England was now thinking about interest rate rises, the governor said: “There should be no doubt that the Monetary Policy Committee is prepared to take whatever action is needed to return inflation to the 2 per cent target and to keep expectations of inflation in the medium term anchored to the target.”

A much tougher statement of intent than he gave in his letter to the chancellor on Tuesday, the minutes of the MPC meeting, published on Wednesday, revealed that the committee had discussed an immediate rise.

The governor made it clear he was not going to go soft on inflation, quite the opposite from his letter earlier this week. He fought back at critics who have called for the inflation target to be changed to ignore current pressures from abroad. “Target growth, not inflation is the cry,” he said. “I could not disagree more.”

“Without a clear guide to the objective of monetary policy, and a credible commitment to meeting it, any rise in inflation might become a self-fulfilling and generalised increase in prices and wages,” Mr King added.

His main message was that if everyone tightened their belts, accepted “a loss of real purchasing power” and understood the Bank could not side-step tough choices in the coming year, things would look up thereafter.

Underlying sales at supermarket group J Sainsbury rose by 3.4 percent in the first quarter of the financial year, putting the retailer behind Tesco’s 3.5 percent increase and Wm Morrison’s 7 percent rise over similar periods.

Sainsbury’s chief executive, Justin King, said today that food price inflation in his branches “was a little over 3 percent in the quarter, up just 2 percent in the previous quarter, but well below official government statistics.” He said he agreed with Bank of England governor Mervyn King that inflationary pressures would continue for the next six to 12 months, adding that “prices for Sainsbury’s non-food items were still showing some deflation.”

Darren Shapland, finance director, said that most of the 3.4 percent like-for-like sales increase came from food price inflation, with “volumes just above flat”. The company’s fuel sales benefited from higher prices and from extra volumes as motorists shopped around for cheaper petrol.

Mr King said he was pleased with the company’s performance in the quarter, which met the group’s expectations. Although the group adjusted the number to take account of the changed timing of the Easter weekend, the quarter compared with a strong period last year, when like-for-like sales were up 5.1 percent.

Mr King said Sainsbury was “fighting hard for customers” whose household budgets are being squeezed by increasing its emphasis on promotional offers, extending its “Basics” range of cheaper foods and launching a “Feed your Family for a Fiver” campaign.

Recent consumer research suggests customers were cutting back on eating out in restaurants which could benefit sales of Sainsbury’s, up-market, Taste the Difference range.

Mr King was happy to report that non-food sales were continuing to “grow strongly” as ranges were expanded. Online sales improved by more than 40 percent, and improvements to the supply chain in recent years meant product availability in shops had risen further.

The company’s total sales in the 12 weeks to June 14th rose by 8.1 percent, given a boost by the increase in fuel prices.

Excluding new store openings like-for-like sales rose 7.3 percent, including fuel sales.

Echoing last weeks trading update from Tesco, which said its growth had slowed from more than 4 percent in the early weeks of its fourth quarter, the 3.4 percent increase in sales marks a slowdown from the 4.1 percent growth Sainsbury reported in the fourth quarter of last year.

Sainsbury shares have dropped since its 600p a share bid from a Qatari-backed investment group was dropped last November - Qatar holds a 24.9 percent stake in the company. Shares were 5p lower in early trading at 331p.

Since gaining independence, the Bank of England’s investors have been more sceptical of the way the bank tackles inflation.

The widening gap between the yields on index-linked government bonds and conventional gilts indicates bon-market investors are willing to pay much higher prices for inflation protection. As Britain enters its most inflationary period for more than a decade this suggests doubts about the credibility of the monetary framework.

Ex-chief economic adviser to the chancellor, and current children’s secretary, Ed Balls described inflation expectations in bond markets as the “most important” test of credibility and confidence in monetary policy.

Paul Dales of Capital Economics said the gap could be the “first sign that the markets are starting to lose faith in the ability of the UK’s policymakers to deliver a low and stable inflation environment”.

Alongside rising surveys of household inflation expectations and corporate pricing intentions, economists said there was a greater risk of higher inflation returning to normal British life.

“In every measure you look at, inflation expectations have already moved out of the range they have occupied in the last eight or nine years.” Malcolm Barr of JPMorgan said.

Sensing that a loss of confidence in the UK from abroad is under way after sterling’s continued decline, Danny Gabay of Fathom Consulting said: “The … markets believe the ‘macro policy miracle’ [since 1997] is more style than substance”.

Over a 20-year period, the government bond market now expects retail price inflation to average 3.76 percent, according to Bank of England figures, compared with 3.47 percent on the last trading day before Gordon Brown announced Bank independence. By comparison, the 20-year expectations two years ago were just 2.85 per cent.

The warning issued by Mervyn King, the Bank’s governor, that the “nice” decade (of non-inflationary constant expansion) was over has prompted other economists to offer their own acronyms. Few yet expect a recession, but Michael Saunders of Citigroup said times will be “vile” – “volatile inflation, less expansionary”.

Urging policy makers to fight higher inflation, Jean-Claude Trichet, president of the European Central Bank said, soaring oil and food prices had created “demanding times, challenging times”, and that the challenge was to ensure the pressures did not create lasting “second-round effects” by feeding through into wage deals.

Mistakes made at the time of the first “oil shock” in the 1970s had “enshrined the high level of inflation for a long period” and led to mass unemployment. Mr Trichet sounded the alarm on inflation even as he acknowledged that financial markets were still witnessing an “ongoing, very significant market correction”.

While we hear news that inflation in the manufacturing sector has moved to its highest level since 1995, many people are starting to ask what inflation actually means to them. So what are the positive points and negative points of inflation?

Inflation is the change in the cost of an item or items over a given time span, normally 12 months, showing how the price of the said item has changed over the period. While it is safe to say that prolonged high inflation will ruin an economy, it is also safe to say that negative inflation or zero inflation also has the potential to cause major problems. Here we list some of the positive and negative aspects of inflation :-

Positive Aspects

Controlled inflation in any economy allows manufacturers and services providers to move the cost of the goods / service higher without pricing themselves out of the market. Inflation is a direct result of the supply and demand levels for a particular product. i.e. if there is little demand then the potential to move prices higher is smaller, yet if there is high demand and few providers, then those in the market can afford to increase their prices.

Increased prices mean increased income and so long as costs are kept under control it also allows the companies involved to increase the salaries of their workers. As incomes rises, more people will spend and the economy will continue to grow.

Inflation is also very important to the property market because inflation will allow rental charges to grow, and because the value of property is normally directly related to the rental income, this will keep the property market moving forward. Again, it is a controlled rate of inflation which is essential because when rental inflation moves out of synch with the market this can cause major problems.

Negative Aspects

While a controlled rate of inflation is good for the economy, a run away rate can have serious implications with costs racing ahead to levels which are unsustainable. The problem seems to occur when people have excess money in their pockets to spend and demand for products is pushed higher and higher. As the cost of the products moves higher there is a natural increase in costs with each element of the production chain wanting a share of the rise – including the workers.

When demand starts to fall many companies are left high and dry with costs which are unsustainable against the falling price of goods and competition. As more companies struggle we see more and more price reductions with many companies forced to sell goods at knock down prices. This can then move the economy into a vicious circle, where cost cutting means more jobs are lost, meaning less money for people to spend which then transfers into reduced sales then to more costs cutting, etc, etc.

Summary

While governments around the world will use different techniques to control inflation, one of the main tools in the UK has been interest rates where the authorities look to make borrowing more expensive to curb overspending, hence reducing demand and prices to acceptable levels. Where demand is falling the authorities would look to reduce interest rates to make borrowing cheaper, giving the consumer the opportunity to borrow and spend – increasing demand. At the moment we are in a very difficult situation in the UK because the cost of oil has increased, which has been passed down the line into business and onto consumers. So prices are rising while the economy is under pressure – a very very tricky situation.

As the oil prices continues to hover around all time high levels we are starting to see genuine concern that the Bank of England may not be able to force through major reductions in interest rates, as many had expected. But how can inflation affect the direction of interest rates?

Historically the weapon of interest rates has been used to either increase economic activity, by reducing rates and making debt cheaper, or increasing rates and making debt more expensive. The cheaper it is to borrow money the more chance of the consumer being in a position to finance their debts and have more money in their pockets, as well as offering more access to funds for businesses looking to invest into their operations.

At this stage of the economic cycle we are seeing consumer demand come under pressure due to the ongoing economic conditions, but we are also seeing businesses increase the price of goods and services directly linked to the price of oil. The increased cost of transporting goods needs to be passed onto the customer at some stage, whether partially or fully, and this is what we are starting to see now. However, there is concern that should interest rates fall to far and the price of oil stays around current levels, we will actually see businesses increase their prices yet further – due in the main to the consumers access to cheaper debt and resulting growth in demand for services / products.

As we see inflation move towards the upper band of the UK government’s target, with many suggesting that it will break through the upper limit very soon, there is potential for a further substantial rise in the rate of inflation as interest continue to move lower. The Bank of England have a very difficult balancing act to figure out, on one hand they need to make cheaper funding accessible to business and the consumer to promote demand, but they also need to ensure that price inflation does not get out of control.

A very very difficult situation to handle!

While there has been much talk in the press with regard to the future direction of UK interest rates, there does not seem to be an awful lot happening at the moment.  So will all of the doom and gloom surrounding the economy actually make a difference?

There is no doubt that over the next 12 months we will see a reduction in UK interest rates, but the speed of the fall and level at which they will bottom out is not yet clear – it will be dictated by what happens over the next few months.  So why are UK rates set to fall?

UK rates will fall due to a mixture of the slowing US economy, which will affect the overall world wide economy, the falling UK property market and the aftermath of the credit crunch.  With so much doom and gloom around many people are asking why rates have not yet begun to fall yet – and they are quite right to ask the question!

The reason why rates are yet to fall in the UK is because of the perceived threat from inflation and the risk which it still may hold in the short term.  A sharp reduction in UK rates could easily fuel the flames of inflation, with the oil price recently hitting an all time high – and oil a major influence on the costs associated with the calculation of inflation.

As soon as the possible threat of inflation reduces we should see the start of lower interest rates and with the economic news set to get worse in the short term, that moment should not be too far away. 

You will often hear economists mentioning the power of inflation, what it can do and how it actually effects everyday life, but what does it really mean for you?

The inflation figure which you will see quoted on TV and in the financial press is produced by comparing the change in the cost of “a basket of everyday goods”  over a certain period.  The goods which are included in the “basket” are items such as mortgages, televisions, food, drink and general grocery items - basically goods which reflect everyday life, and the popularity of the item.  This “basket” will actually change over time, as some items become less popular and other items are introduced.

The end result is the inflation figure, which gives the average price increase of the “basket” over the period in question - normally twelve months.  If inflation is running at high levels, then it means that the economy may be running out of control and you would normally see the Bank of England intervene in the UK.  The UK government are currently looking to keep inflation in the 2.5% to 3% range which they believe is manageable.

What problems might inflation cause?

If inflation gets out of control as the economy grows at a pace which is probably unsustainable over the longer term, this can result in the so called “boom and bust” scenario.  In effect, as prices rise, there is pressure to increase wages, which then increases costs for business, requiring further price rises - in effect a vicious circle on increases.  At some stage the consumer will not be able to afford the items, as the rise in their income will probably be less that the rise in prices. 

This would then impact upon the profitability of industry in general, which may well push them towards saving costs, with redundancies the probable outcome.  As the number of unemployed increases, then we see spending reduce yet further, putting more pressure on not only industry, but the housing market.  Debts may spiral out of control, we may see an increase in house repossessions and a general collapse in the economy.

During the boom phase of the cycle, we may well see the Bank of England increase interest rates to cool down the situation.  This is a short term pain, long term gain scenario, which is required to bring the economy back under control.  In summary, a little bit of inflation is good, but rampaging inflation can ruin an economy for many years and have devastating effects on the population.

“The King is dead, long live the King” - in the words of an old saying.

Inflation is most definitely not dead, never has been and never will be.  There are periods in history where inflation has both ravaged economies throughout the world, as well as times where it has been under control for long periods. The UK has been fairly lucky in that apart from a couple of period where inflation got out of control (e.g. 1987, etc although even these periods only saw high single digit inflation) we have not suffered any where near the likes of Brazil, etc where historically they have seen inflation levels in the thousands of percent a month.

What is inflation?

Inflation is basically the factor by which assets, costs, services, etc will grow in any one given period. In the UK the current annual rate of inflation is just under 3%, which while a little way above the UK authority’s target of 2%, is not really a major concern at the moment.  However, if left unchecked it can easily get out of control - hence the recent rate rises by the Bank of England.

Does inflation really effect me?

Inflation effects us all in our everyday lives, at work and at home and has the potential to bring great joy or despair.  It will effect the price you pay for a loaf of bread, the cost of your home and many many more areas of society which you may take for granted.

Perhaps the largest effect inflation may have on the everyday consumer is at work, and the amount by which your salaries rise year on year - depending upon inflation.  In simple terms, if inflation has risen by 2% over a 12 month period, then your salary will need to rise by the same amount to give you the same spending power.  It is all to do with relative terms, and the effect they have on your spending power.

If you salary was increased by less than the rate of inflation, then in real terms the value of your income would be eroded and reduced - giving you less buying power.  On the other hand, if you were able to agree a salary rise above the rate of inflation (most unlikely!) then you spending power would increase in relative terms.

Is inflation all bad?

While we often talk about inflation in derogatory terms, it is an essential part of any economy.  If there was no inflation then manufacturers would not be able to justify rises in the cost of their products or services, resulting in no salary rises, etc, etc.  A little bit of inflation is good - too much can be very very bad!

Conclusion

Inflation has the ability to surprise everyone, and especially those who think it is dead and buried.  It is most definitely alive and kicking, and without due care and respect it can quickly ravage even the strongest economies of the world.