Inflation is low and retail sales are strong. Next week’s official numbers are likely to show that consumer price inflation (CPI) inflation is below its 2 per cent target and that retail sales volumes are more than 3 per cent up on a year ago – retailers’ problems are low margins and the rise of online shopping rather than volume growth.
What might surprise you is that this combination is by no means unusual. We often see low inflation and strong retail sales together, and higher inflation and weaker retail sales. Since 1996 the correlation between annual consumer prices index (CPI) inflation and annual growth in sales volumes has been hugely negative, at minus 0.65. We saw low inflation and strong retail sales in much of the late 1990s and in 2015, and we saw higher inflation and weak sales in 2008-09, 2011 and 2017-18.
One reason for this was pointed out by Julio Rotemberg and Garth Saloner back in 1986. Price wars, they said, were more likely in booms than in slumps. This is because when there are more customers around, retailers will fight to win them in the hope the customers will keep coming back to them.
But there’s another reason. It’s that the biggest causes of variations in inflation in recent years have been fluctuations in commodity prices and sterling. Low oil prices and a strong pound in the late 1990s cut import prices and boosted our real incomes, thereby triggering rising spending. Higher oil prices and a weaker pound in 2008 squeezed our real incomes and depressed spending, and the fall in sterling in 2016 again raised import prices and so squeezed real incomes and retail sales.
What we’ll see in next week’s figures is therefore a normal response to the fall in oil prices late last year.
Which is a problem, because that fall has recently been partly reversed. Having dropped from over £60 a barrel to £42 between October and December, Brent crude has since recovered to £49 a barrel. As this rise hits petrol prices and heating bills, our incomes will be somewhat squeezed again. And this might hit retail sales quite soon.
In itself this is no big deal. But it is not the only danger for retailers. With productivity still flatlining real wages won’t rise much anyway, which will also cap sales growth.
This, however, is not the only issue here. The strong negative correlation between inflation and retail sales growth brings into question a conventional theory of inflation – one that dominates the Bank of England’s thinking – which is that stronger demand tends to raise prices. In fact, inflation seems to be moved more by supply shocks – such as changes in commodity prices or (some would add) productivity – than it is by demand. Which suggests that the current strength of sales volumes should not be very inflationary.
