It reduces companies’ average costs and so protects their profitability during the period of weak demand. A by-product of this adjustment, however, is that the marginal cost of producing additional output is higher. Although the mothballed capacity can be reinstated, it is likely to be more costly to do so, especially in the short-run, than if the resources were simply standing idle. Assembly lines need to be serviced before being restarted; staff need to be brought back from sabbaticals. As a result, the downward pressure on costs and prices stemming from the latent spare capacity within companies, at least in the near term, is likely to be less. 6 Developments in margins Consider next the mark-up over and above costs that companies include in their selling price. In the past, margins in the UK have tended to fall back during periods of weak demand and vice versa. 7 One possible reason for this is if companies reduce their prices relative to their costs when demand is weak in order to gain market share which they hope to hold onto as demand increases, ie they hope to be able to exploit some degree of pricing power. If successful, the lower profits in the downturn are outweighed by the gains during the upswing. This pro-cyclicality of margins is another reason why inflation in the UK has tended to moderate during periods of weak demand. But margins appear to have fallen by less during the recent recession than expected given the marked contraction in demand.
My central view is that the peak impact of the past depreciation on inflation has probably passed – monthly goods price inflation has slowed in recent quarters and the total adjustment in relative prices is similar to previous exchange rate changes. But there is considerable uncertainty surrounding this judgment and it is quite possible that there may be further significant upward pressure on prices to come. The increase in prices associated with the combination of the rise in oil prices, the changes to VAT, and the past depreciation of sterling is more than sufficient to explain the strength of inflation relative to target. Moreover, the fact that some of these factors were not predictable in advance and that their implications for inflation – particularly so in the case of the exchange rate – appear to have been greater than initially anticipated, can also help to account for the upside surprises in inflation. But the exact contribution from these price-level shocks is uncertain and it is possible that the other factors identified by the pricing framework also contributed to the surprising strength of inflation. The impact of spare capacity on costs and prices Consider first the impact of spare capacity on costs and prices. There are good reasons to believe that a substantial margin of spare capacity opened up during the recession and remains today.