UK price inflation: 'Sticky' but set to fall further
Mon, Aug 24 2009, 11:33 GMT
by Trevor Williams
UK consumer price inflation stubbornly high...
In July, UK price inflation was well above financial market expectations, recording a 1.8% annual print, significantly higher than the consensus estimate of 1.5%. The ‘core’ rate, which excludes food, energy, tobacco & alcohol, rose to 1.8% from 1.6% in June, while both key measures of retail price inflation were also higher at -1.4% (RPI) and 1.2% (RPIX). Although the latest data contrast with the view from the Bank of England that inflation will slow in the near-term (largely due to base effects such as past hikes in utility prices falling out of the annual comparison), the Inflation Report also noted that the monthly profile was likely to be unusually volatile in H2 2009. Month-on-month rates for CPI, core CPI, RPI and RPIX were all unchanged in July compared to June, against expectations of falls of around 0.3%.
...but the trend is downward...
But the big picture trend is that UK price inflation is falling, and was below the Bank of England’s 2% target for a second consecutive month at 1.8% in July, see chart a. Retail price inflation is falling more sharply than consumer price inflation (CPI) because it is more affected by the two and a half percentage point cut in VAT and lower interest rates, but it is the CPI that we will focus on, as it is the key measure used to compare price inflation trends between countries. Looking internationally, the fall in UK price inflation is slower than in other comparable countries, see chart b. The chart shows that US CPI inflation was -2.1% in July, and that eurozone inflation was -0.7%. In Japan, there was deflation of -1.8%, a record low in a decade of falling prices.
But should the inflation outcome for the UK not be viewed as a success for the Monetary Policy Committee (MPC), as the strategy around quantitative easing (QE) is to avoid inflation falling too far below the 2% target? The answer partly lies in whether CPI inflation stays at current levels or falls significantly further in the period ahead – following the path already taken by the other economies shown in chart b. Hence the question: is UK CPI inflation ‘sticky’, i.e., resistant to falling because of some fundamental or structural problem with prices in the UK or will it drop significantly further in the next few months? The official position is clear on this point: ‘It is more likely than not that inflation will temporarily fall below 1% in the autumn...’. The central forecast also shown in the Bank of England’s August Quarterly Inflation Report is that CPI inflation, even on the basis of Bank rate remaining at 0.5% and £175bn of quantitative easing (QE), ends up below the 2% target in two years time.
...and official forecasts show CPI inflation below 2% in 2 years time...
This means that as far as the MPC is concerned there is no barrier to CPI inflation falling further in the UK. The minutes of the August MPC even suggested that the MPC was prepared to write an open letter to the Chancellor explaining why inflation had fallen by more than 1% below the 2% target - just as they had to write letters last year explaining why it had risen by 1% above the target. So why, so far, has UK CPI price inflation not fallen as much as it has in the US, eurozone or Japan, as highlighted in chart b?
Wage inflation, one of the major influences on price inflation, does not appear to be a reason why UK CPI inflation is higher than in other major developed economies. Chart c shows that UK wage inflation has fallen back as much as the average of other countries. Another major component of CPI inflation is import prices. Chart d shows just how well correlated UK price inflation is with import prices: falling import price pressure means falling CPI inflation pressure.
As import prices have a big role to play in generating CPI inflation, comparing the UK with other major developed countries might be useful in drawing out the differences in CPI inflation between them. Chart e which shows that UK import price falls are not as sharp as in the other countries. This partly explains why UK CPI inflation has not fallen as much as in these other economies. One of the key reasons why UK import price inflation has not fallen as much is due to the rapid depreciation of the pound. Some 13% of the near 30% decline over the last year has been reversed since March, see chart f. If maintained, this implies that UK import price inflation could fall back further. But another reason for believing that UK CPI inflation can fall further is the large negative output gap, the extent to which actual output is below potential output.
...though likely to take a volatile path, CPI inflation will be driven lower by a large negative output gap
The near-term path of CPI is likely to remain volatile, but our forecast shows that it will fall below 1% in September, prompting an open letter to the Chancellor from the Governor of the central banks, see chart a. UK CPI inflation will remain below 1% for some months, and then gradually rise back as economic recovery resumes and the effects of a rise in VAT impact in year on year comparisons. But the large amount of spare capacity in the economy will bear down on inflation in the medium term, even accepting that some of the lost capacity may be scrapped and never brought back into actual production. Based on the economic profile and the implied output gap, a long period of low UK inflation lies ahead. Hence, it is entirely possible that despite a return to positive UK economic growth in Q3, the Bank of England may still embark on more quantitative easing in November.
