The Ernst & Young ITEM Club - an independent economic forecasting think tank which uses the same economic models as the Treasury - has today published a report on the inflation outlook for the UK over the short to medium term [PDF]. Coverage of this has been slow and not terribly helpful. I caught a snippet on Radio 4, but to get anything even vaguely meaningful, you would have had to listen to Radio 5 Live's Wake up to Money at 5.30 this morning.

On Wake up to Money, Neil Blake, a senior economic advisor at the ITEM club suggested that a lot of the inflation we have seen over the last three or so years has been "imported" or outside the control of the Bank of England's Monetary Policy Committee (MPC). This kind of imported inflation was due to sharp increases in commodity prices, primarily food and energy. "Domestically generated inflation", he said, was relatively low. Given the economic outlook, Mr. Blake suggested, the MPC's current inflation target of 2% may be unrealistic and he proposed two options for addressing this:

• Option 1 would be to increase the MPC's inflation target. Even a modest increase of half a percentage point for 2.5% would give the MPC considerable flexibility to absorb imported inflation.
• Option 2 would be to target a different measure of inflation - one that allowed us to strip out elements beyond our control such as food and energy, and enabled us to focus on the "domestically generated" part of inflation.

It is that "domestically generated" inflation that I want to look at. In basic terms, inflation is a general rise in prices: items which yesterday cost you £1 to buy today cost £1.02. The same amount of money, therefore, buys less "stuff". Obviously increased prices of raw materials or energy will have an impact on inflation. So will raising sales taxes such as VAT - something which has happened twice in the last two years, once at the reversal of the temporary VAT cut and once at the beginning to this year when the rate went up to 20%. These are either external factors beyond our control or one-off occurrences which will not affect inflation next year. There are, however, other factors domestic factors which can influence inflation, and by far the biggest of those is wages, followed by profits. These are the "domestically generated" pressures on prices and components of inflation. What Neil Blake is therefore saying is that while food and energy prices will continue to rise and that is beyond the MPC's control, one way of keeping inflation down is to focus on - essentially - keeping wages down. It is an interesting euphemism, that "domestically generated inflation".

In all fairness, if you read the full ITEM Club report, a slightly different picture emerges. Far from making any specific recommendations, the report acknowledges the weaknesses of both options. It stresses that any attempt to keep the domestically generated parts of inflation down is likely to have a strong negative impact on growth and thus highlights the challenges facing policy makers. It also looks at the shares of wages and profits in gross output - in other words, how much of GDP goes to labour and how much to capital. There are a few items of note here:

• Over the last 40 years, there is a slight but perceptible downward trend in labour's share of GDP and an equally slight but perceptible upward trend in capital's share. The downward trend for wages as a share of GDP is particularly pronounced from the 70s until the mid-90s (say around 1997), after which labour's share of the pie stabilises.
• The ITEM club looks at the effect that changes in the share of GDP of imports and indirect taxes have on the shares of labour and capital. What they find is that taxes tend to squeeze labour's share of the economy, not capital's.
• Globalisation, together with rising commodity prices and competition in international labour and product markets, is likely to further squeeze labour's share of the pie.
• Finally, "the recovery when it comes will benefit capital more than labour." This will, of course, further exacerbate already high levels of inequality in the UK.

Overall, the ITEM club report makes for very interesting reading and acknowledges that we will continue to face economic challenges over the short to medium term. The most important conclusion I draw from the report is this: If the government suddenly decides to change what the Bank of England is targeting in its efforts to manage inflation, and particularly to "exclude factors beyond our control", remember what this means. Remember that "targeting domestically generated inflation" is code for "keeping wages down".

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