Retail sales no longer reflect consumption

WORST CHRISTMAS yet and foretaste of recession to come? Or a perfectly reasonable Christmas for sensible traders and a foretaste of life in a zero inflation world?

The poor retail sales over the festive period are really just a starting point for a much more interesting discussion about the nature of commercial activity in a world of transparent pricing.

Just how bad the UK retail sales really are will gradually unfold. The best rule is not to trust the initial figures, but wait until any revisions have been completed. In this case wait until we have the January figures too, for swings between the two months often occur as bargain hunters delay their purchases to get lower prices in the sales (trick: give people vouchers for a Christmas present instead of the present itself - they end up getting a better present, or at least the same one at a better price).

Even when the final numbers emerge, expect the headline figures to be disappointing, as one might expect at this stage of the economic cycle. But in five or 10 years, the cyclical aspects of the story will be lost in the mists of time. People will focus instead on the decreasing importance of retail sales as an indicator of consumption and the rising significance of pricing transparency.

There are several aspects to the decline of retailing. As we get richer we tend to spend more on services and less on things. That is partly a price effect. Inflation in services has consistently been higher than that of goods. This phenomenon has been most evident in the US - the graph on the rightshows how consistent the trend has been - but is evident in all developed countries.

But this is not just a price effect; the volume of services bought is rising too as we get richer and, crucially, as we get older. We(hopefully) all know the effect of rising income. The proportion of income spent on goods, and particularly goods bought through retail stores, tends to fall. Instead we spend more money on services - financial services, leisure, travel and entertainment, personal services. We don't buy so many goods because we have got the goods already; but we do choose to make life more comfortable by buying services.

The changing age structure of the population reinforces this trend: the older that people get, the greater the likelihood that they have already bought the thing but need to buy the service - even if their incomes are not rising.

Finally, conventional retailing may not be picking up the changes in spending pattern. If you buy a book from a bookshop that is in retail services. If you buy it on line from Amazon.com it isn't.

More and more computers are bought online, by-passing conventional channels.

The key point here is that retail sales are becoming a smaller and smaller proportion of consumption, so a bad Christmas in the shops may not necessarily mean a bad Christmas for consumption.

Expect this non-retail segment of consumption to surge in the years to come.

The other new and important feature is the impact on very low inflation on the attitudes of shoppers. There are several aspects to this.

The prospect of falling prices changes the relationship between buyer and seller. If prices tend to rise, the buyer knows that he or she should move quickly: the price in the future will be higher. If prices tend to fall, the buyer knows that waiting may result in a lower price. So there is much less incentive to buy at the time of choice of the seller.

Next, very low inflation has mathematical impact on prices. Look at the graph, which shows this in a stylised way. On the left-hand side is an average inflation rate of 10 per cent. One standard deviation above that gives 15 per cent inflation, one standard deviation below, 5 per cent. Now inflation is 2.5 per cent. One standard deviation above gives a price rise of 7.5 per cent, one standard deviation below, minus 2.5 per cent. Relative price changes now are as large as they were then, so that to maintain an RPI at 2.5 per cent means that the prices of some goods will be falling at 2.5 per cent a year.

True, nominal interest rates are lower, so the carrying cost to the manufacturer or retailer of goods that fall in price ought not to be much higher than the carrying cost in an inflationary period. But that assumes that the enterprise is relying on short-term finance. If it is stuck with expensive capital from bonds issued years earlier, or fixed-rate bank loans, it may be in trouble. Just as inflation rescued borrowers from bad investments, deflation is punishing them for these.

Now look forward. We cannot assume that inflation will remain at 2.5 per cent. Inflation on the Continent, admittedly calculated on a different basis, is now below 1 per cent year-on-year. That may be partly the result of one-off factors, and core inflation is put at 1.6 per cent. Nevertheless it is perfectly plausible that inflation will remain at below 1 per cent for some time. If it does, the UK target will appear incongruously high. That may be a case for changing the basis of calculation, for on a harmonised basis our inflation is much close to that of euroland. But it is not below 1 per cent yet. The sensible working assumption is surely that UK inflation will carry on downwards in the next few years.

In a world of more or less stable prices, people will become immensely price-sensitive. We are so used to prices changing that we find it hard to imagine the consequences of price stability. Once we become accustomed to the normality of stable prices we will react very badly to companies, retailers or governments who try to stick them up.

As poor M&S found at Christmas, if people feel goods are over-priced they will keep their cash until the retailer cracks and cuts the price.

That is really the new thing: welcome to the world of purchaser power.