Revisiting the UK inflation outlook
Mon, Nov 16 2009, 11:07 GMT
by Lloyds TSB Financial Markets Economic Research Team
There have been some important developments on the UK inflation front recently. Firstly, the ONS has published a consultation document outlining proposed changes to the way mortgage interest payments are captured within the RPI. The changes, if implemented, could have important consequences for the volatility and profile of retail price inflation from early next year. Second, the Bank of England (BoE) recently published its latest Quarterly Inflation Report (QIR). The QIR outlines the MPC’s updated views on gdp growth and consumer price inflation. In this Weekly, we examine these developments and assess their implications.
Proposed change to RPI mortgage payments
In a recently published consultation document, the ONS’s Consumer Price Advisory Committee (CPAC) has recommended that a different measure be used to more accurately capture the mortgage interest payments (MIPS) component of the RPI. Currently, MIPS are calculated solely on the Standard Variable Rate (SVR) and thus exclude the cost of fixed rate and tracker mortgages. To correct for this, the ONS is proposing to use a wider measure of mortgage interest, the Average Effective Rate (AER), which includes tracker and fixed rate mortgages. As chart a shows, the AER has generally been below the SVR in recent years, as the rates paid on fixed and tracker mortgages have tended to be lower than the SVR. Over the past eighteen months, however, the gap has reversed, as the unprecedented fall in Bank Rate has pulled the SVR down sharply.
So what impact would changes in the way MIPS is calculated have on the RPI? Chart b shows annual RPI inflation and the outturns that would have prevailed if the AER had been used instead of SVR. Since 2005, the average difference between the two measures is relatively small at 0.1 of a percentage point. The average absolute difference, however, is 0.4 of a percentage point, largely due to the widening gap that has emerged over the past eighteen months as a result of the sharp fall in the SVR. Had the ONS moved to the new measure in June, annual RPI inflation would have been –0.4% rather than the –1.6% reported.
Looking ahead, if the change is implemented for the February 2010 RPI, the impact will depend on the relationship between the SVR and the AER at that time. At the moment our best guess is that the annual rates of both mortgage payment measures will converge over the coming months, as prior cuts in the SVR drop out of the annual comparison. If so, any change resulting from a move to the AER is likely to be modest, although we suspect there could be a slight upward revision. Further out, the impact will depend on the evolution of Bank Rate, mortgage spreads and swap rates (which are used to price fixed rate mortgages). If the swap curve flattens, as financial market forward rates suggest, the RPI is likely to be slightly lower than would otherwise be the case over the next two years.
It is not only the value of the RPI that would be impacted by the proposals, however. RPI inflation is also likely to be less volatile, as MIPS respond to changes in a wider range of mortgage interest rates. The volatility of the SVR is typically far higher than the AER (chart a). This is likely to remain the case over the coming years, particularly once Bank Rate starts to move higher.
For companies that have RPI-linked debt and/or receivables, the proposed changes could have important consequences for their cashflows. If the change is implemented from next February, companies could face the prospect of slightly lower, and potentially less volatile, annual RPI inflation over the medium term.
Bank of England Inflation Report
From the BoE’s perspective, the evolution of the RPI has little direct bearing on monetary policy, as the government’s inflation target is the CPI, which excludes MIPS. From a policy perspective, the more important inflation development recently has been the publication of the BoE’s latest Inflation Report. The Bank’s updated CPI inflation projections are shown in chart c. Based on market interest rate expectations, the Bank expects CPI inflation to rise from 1.1% currently towards 3% early next year, driven higher by a reversal of the 2.5% percentage point VAT cut planned in January and base effects associated with higher petroleum inflation. Thereafter, however, CPI inflation is forecast to drop back, reaching a low of around 1.5% in late 2010, before drifting towards the 2% inflation target in two years’ time.
The relatively weak profile of the Bank’s CPI inflation rate over the medium term is reinforced by its perception of the balance of risks. The fan chart shows that over the period as a whole the distribution of risk is clearly skewed to the downside. The Bank’s benign mediumterm inflation assessment reflects its view that a persistent high level of spare capacity – encapsulated in a large output gap – will continue to bear down on price. The degree of spare capacity is already evident in the rise in unemployment and the marked decline in average earnings growth over the past two years.
Although the Bank cites persistent spare capacity as keeping inflation pressures at bay, its CPI projections are predicated on a surprisingly strong recovery taking hold. It expects output to rise by 2% in 2010 and by 4% in 2011. These projections are well above our own and the market consensus estimates, of 1.3% and 1.9%, and 0.7% and 2.3%, for 2010 and 2011, respectively. Although our gdp projections differ, we share the Bank’s view that inflation is likely to rise above 2% over the coming months, before falling back towards the 2% target thereafter. Our profile for RPI and CPI inflation are shown in chart d.
Further stimulus cannot be ruled out
We believe that the pass through of the steep fall in sterling’s exchange rate and the anticipated pick-up in demand to final prices will be slightly faster than the Bank is projecting. Thus, we arrive at a similar inflation forecast, but with a more modest assessment of the growth outlook. That said, given the Bank’s upbeat gdp projections, one might conclude that there is ample scope for gdp growth, and presumably inflation, to undershoot its forecasts, potentially requiring further stimulus. What seems clear is that underlying inflation pressures are likely to remain benign for some time to come. Faced with this likelihood, BoE Governor King is right at this stage not to rule out the possibility of further quantitative easing next year. The financial markets are priced for a rise in UK Base Rate from the third quarter of 2010. Given the Bank’s latest Inflation Report, such expectations could well be premature.
