08/01/2013 07:39 GMT | Updated 10/03/2013 05:12 GMT

Inflated Forecasts?

While 2012 will long be remembered for the magnificent London Olympic and Paralympic Games and the Queen's Diamond Jubilee, it will not be fondly recollected by Britain's small businesses. According to the Government's independent Office of Budget Responsibility (OBR), the British economy contracted 0.1 per cent over the past twelve months, down from predictions of a 0.7 per cent increase just twelve months earlier and, alarmingly, down from predictions of a 2.6 per cent increase in the autumn of 2010. It means that the economy has not grown for five years, meanwhile private-sector investment has stagnated and is nearly twenty per cent below its pre-recession levels, household consumption has yet to recover to its pre-2007 level and the cost of living is still rising faster than wages.

Looking ahead, the OBR predicts growth of 1.2 per cent for 2013 and while this too has been revised down from 2.1 per cent a year ago, it is based on expectations that inflation will be lower in 2013 than 2012 and that household consumption will be higher this year than last, not to mention acknowledging the fact that general Government consumption is predicted to fall by 0.7 per cent in 2013, after a rise of 2.4 per cent last year.

That inflation remains above the Bank of England's two per cent target, despite the economy suffering the worst recession in living memory, experiencing no growth and unemployment close to eight per cent, should be of concern. The effect of the VAT increase on inflation during 2011 and of higher tuition fees toward the end of 2012, not to mention the unpredictability of global food and fuel prices should serve as reminders that while wage growth remains subdued, the impact of inflation in an economy reliant upon consumption ought to be given more consideration by Government. Yet even excluding these one-off factors, underlying inflation remains resilient and thus, worthy of further consideration.

Unit labour costs, which have grown at or above their historical rate for much of the period since the financial crisis, represent the single greatest determinant of most companies' costs and thus offer an insight into the origins of the underlying inflationary pressures we are currently experiencing. Much has been made of the fact that the economy has 'created' over one million new jobs in the last two years - without growing at all. In other words, private sector productivity is now eight per cent below its 2007 peak. The second contribution to the increases in unit labour costs is the substantial changes in relative prices, caused by the depreciation of sterling and increases in fuel and VAT, all of which also affect the competitiveness of British international trade.

The impact of these changes has been significant; in order to maintain profitability, companies have needed to offset the impact of weaker productivity and stronger price pressures, by constraining wage growth and increasing prices, which has, in turn, further reduced household consumption, but increased inflationary pressures. Thus, one of the key factors affecting the future resilience of the rate of inflation - and through it, the UK's economic recovery, is the degree to which the private sector still needs to restore its margins.

Businesses like my own, from all across the UK, will tell you that while 2012 was a more positive year than those before it, there remains a demand deficit - there are simply not enough customers walking through the door - and thus, it is extremely difficult to fully restore margins with any speed. In short, inflation will remain resilient throughout 2013, wage growth will remain restrained and, as the global economy continues to slow, export growth will continue to be suppressed. Under those circumstances, the OBR projections of 1.2 per cent growth for the year look a little optimistic.