Words, Words, Words

04/03/2011 at 11:44 am 1 comment

Jean-Claude Trichet, ECB President, set markets on fire yesterday. Interest rates didn’t change, but he confirmed that the use of the phrase “strong vigilance” on inflation in the ECB’s policy report indicates that a rise next month is now “possible”. Though definitely not “certain”. And it would not indicate a “series” of increases.

After a few minutes of these open mouth operations the euro rallied to a new four-month high against the dollar, the two year German government bond yield rose to a new post-recession high and bond markets in general were inspired to give up a fair chunk of their recent Gaddafi premium.

Monsieur Trichet paid particular attention to the spike in energy prices, noting that the ECB would act to counter any sign that it was filtering through into wage negotiations (so-called “second-round effects”). In some sophisticated corners this will not go down well. Doesn’t Trichet know that rising oil prices, rather than an inflationary menace, are a “tax on growth” that will reduce demand and end up containing inflation?

Now “tax on growth” is a nicely turned phrase. Let’s have a look at what it means.

First off, energy is a basic need. People and businesses need the electricity provided by oil- and gas-fired power stations; they need to keep cars and lorries on the road. They will pay for this energy no matter how much it happens to cost, so long as they can still afford it (“price inelastic demand” in the textbook jargon).

So, when energy prices go up, the amount of income consumers have to spend on other things must go down. Likewise, absorbing the shock of higher energy costs reduces business profits. Non-energy demand falls, growth falls and inflation is not an issue.

Except …

Quite a lot of businesses, and the consumers that they employ, stand to benefit from higher energy costs. Oil and gas producers comprise some 16% of UK stock market capitalization and employ about 300,000 people. So the “tax” parallel isn’t quite right. (This is especially true when you broaden the net of potential beneficiaries to include those who supply this sector, such as engineering firms.)

In addition, not all the impact of higher energy costs is absorbed by businesses – they pass some on in the form of higher prices. So the oil “tax” payable by the business sector begins to look like VAT rather than corporation tax in that it is levied ultimately on consumers.

From the consumer’s point of view, then, they end up paying more for petrol and electricity, and more for goods and services supplied by firms who also have to pay for those things. Which, to a greater or lesser extent, is all of them.

Looking at the argument from the other end again, aren’t higher food prices also a “tax on growth” by the same token? And higher metals prices?

In fact, don’t we already have a better word than “tax” for this demand-dampening mechanism that benefits certain portions of an economy while prices rise at the whole-economy level? Isn’t it spelt: I, N, F, L, A …

In other words, high oil prices are only a “tax on growth” in the sense that inflation is a tax on growth, and more expensive oil is a direct, indirect and second-round source of inflation.

Which is exactly what Trichet was on about.


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