UK now in deflation but only temporarily

UK CPI inflation was in deflation in April as the annual growth rate in the consumer price index fell to -0.1%, down from 0.0% in March (Danske Bank: 0.1% y/y, consensus: 0.0% y/y). This is the first time since the official records began in 1996 and the first time since 1960, based on historical estimations. Core inflation dropped against expectations to 0.8% in April from 1.0% in March.

The largest downward contribution to the fall in CPI inflation from March to April came from air tickets, which fell 5.3% y/y. This component alone pulled the inflation rate down by 0.1pp. The ONS states that this may be due to the timing of Easter. The cheaper air tickets may also be due to lagged effects from the lower oil prices and increased competition. Cheaper air tickets also explain the fall in core inflation.

As expected, the largest upward contribution came from fuel prices, which increased in line with the oil price in April. Motor fuel prices increased 1.6% m/m in April and pushed the inflation rate up by 0.05pp. This was as expected. Although electricity and gas prices declined 0.1% m/m, the annual price change declined to -1.9% from -2.3%, implying that there also was a small upward contribution from gas and electricity prices. The total energy component pushed inflation up by 0.08pp. That said, the fall in energy prices is still a major reason why headline inflation is as low as it is.

Inflation in non-energy industrial goods (NEIG) was unchanged at -1.0% y/y, implying that there was no further downward contribution from NEIG despite the strong GBP.

Services inflation fell to 2.0% y/y in April down from 2.4% in March. This is the lowest reported since records began in 1996. This fall was also caused by cheaper air tickets. Higher inflation in services prices is needed for the Bank of England to hit its 2% inflation target, in particular since the strong GBP puts downward pressure on import prices.

As mentioned, the UK is now officially in deflation, but this is very likely to be temporary. We expect CPI inflation to pick up sharply in H2 when the base effects from the declines in energy and food prices begin to drop out. Mark Carney, Governor of the Bank of England, has on several occasions stated that inflation could turn negative, implying that today’s figure should not affect the individual views of the members of the Monetary Policy Committee. The very low inflation is good news for UK citizens who are experiencing positive real wage growth for the first time since 2009, which supports private consumption and hence the recovery.

We still expect the MPC to hike in November this year as the medium-term inflation outlook, in our view, still calls for tighter monetary policy. However, as core inflation is also low and sterling is strong, the MPC can be more patient with the first Bank Rate hike, which continues to be a downside risk to our current call.

See the following page for illustrative charts.