Inflation is with us for three main reasons. Firstly, energy costs have risen dramatically over the past 18 months. This has had the knock-on effect of increasing the day-to-day cost of doing business for food retailers and their suppliers. Distribution costs have ballooned, as have production expenses. However, with the oil price having fallen in recent weeks, this will be a lesser force for grocery price inflation in the coming months.
Secondly, and more problematic looking forward, will be product inflation. We have already seen material price increases in fresh produce, due to unhelpful weather conditions in the spring and
early summer: indeed deflation in produce prices of 5% has been replaced by inflation of 10%. This will continue to be an issue, but more recently it's been easy to spot some price increases in wheat (prices at a 10-year high), meat and fish. BSE concerns have emerged in Brazil and demand for British beef has risen dramatically. Demand is continuing to outstrip supply of fish. These pricing pressures are unlikely to ebb away as we move into 2007.
Thirdly, competition on price in the industry has eased a touch in recent months as the battle-ground has moved away from price to quality. From the sofa I counted four different food retailers advertising their premium brands and fresh food offers on TV the other night. Two of them were Asda and Morrisons, who hardly have a heritage at the quality end of the market. But it seems Brits want to be healthy and they want to help the environment - if it costs them a few pennies more, that's fine. Squabbling over who sells the cheapest baked beans is yesterday's war. It's hard to see this 'flight to quality' changing, either.
So there have been three drivers of inflation, and two of them are hanging around. Shares in food retail companies have enjoyed a great summer and autumn so far. If we're right on inflation, the knock-on positive impact on their P&Ls means that the outperformance will continue.