How big a risk is UK inflation?
Mon, Jul 19 2010, 11:10 GMT
by Trevor Williams
The persistent overshoot of UK CPI inflation above the government’s 2 per cent target has started to raise concerns that price pressures are becoming entrenched. In 19 of the past 27 months, annual CPI inflation has exceeded the market consensus expectation, suggesting the models adopted by the economics community have failed to fully capture the current dynamics driving UK inflation or its measurement. In June, the annual CPI rose by 3.2%, the eighth consecutive month it has been above the 2 per cent target. Other key measures of UK inflation have been similarly strong.
The elevated level of UK inflation stands at odds with price trends elsewhere. In many other developed countries, inflation has either fallen or remained low as spare capacity in the product and labour markets has constrained the pricing power of both employers and employees (as traditional output gap models would suggest), see chart a.
To date, the relatively high inflation outturns in the UK have generally been dismissed as temporary, reflecting the coincidence of various one-off factors that could be expected to wash out of the inflation rate over time. Principal amongst these are the rise in VAT earlier this year, the unusually sharp rise in petrol and secondhand car prices over much of 2009, and the lagged impact of earlier sterling weakness on import prices.
Adjusting for these “temporary” factors, the inflation environment does indeed appear far more benign. Excluding the rise in indirect taxes, for example, annual inflation (measured by CPIY) has declined from 3.1% to just 1.6% over the past year. Furthermore, the composition of UK inflation suggests the rise has been heavily influenced by the increase in transportation costs. Rising transportation costs alone contributed 1.4 percentage points (pp) to annual CPI inflation in June (see chart b). Over time, these “temporary” influences should fade.
Nevertheless, it is becoming increasingly difficult to argue that inflation is being driven by these “temporary” influences alone. Although headline inflation has dropped from a peak of 3.7% to 3.2% in recent months, “core” inflation (exc food and energy) has remained broadly unchanged at around 3%. It is clear that underlying inflation pressures have not eased as sharply as expected given the challenges facing the UK. The stickiness of inflation has been particularly noticeable in the services sector. While goods price inflation has fallen by over 1pp since January, services inflation has risen by broadly the same amount.
The resilience of core CPI inflation, coupled with the recent rise in UK inflation expectations, has begun to raise doubts on the MPC about how quickly inflation will fall back. The 2.5 pp rise in VAT next January only adds to the uncertainty.
Notwithstanding this, we expect underlying inflation pressures to moderate over the medium term. Although estimates differ, there is little doubt that the UK is operating with significant spare capacity. This spare capacity is clearly evident in the labour market. The level of employment has fallen by over 1mn since early 2008, nominal wage growth has stagnated, while real wages and unit labour costs are both now falling. Although economists may have fallen short of accurately forecasting inflation in recent years, with appropriate lags, there remains a reasonable correlation between inflation and the degree of economic slack. Chart c shows the relationship between the UK output gap and the change in RPIY inflation (retail prices excluding mortgage interest payments and indirect taxes). We have chosen RPIY instead of CPIY as it has a much longer history, but the two series are closely related.
The chart suggests that the output gap leads changes in annual RPIY by around four quarters. When the output gap is negative (i.e. the level of output is below potential) inflation tends to fall, and vice versa. The relationship suggests that inflation pressures are likely to moderate sharply over the coming years.
Nevertheless, as the shortcomings of UK inflation forecasts in recent years have highlighted, this output gap analysis does not provide a complete picture. The UK is a relatively open economy that is highly sensitive to external price shocks emanating from currency or commodity price movements. Our forecast assumes that neither movements in sterling nor commodity prices contribute significantly to changes in the inflation outlook over the coming years.
It also makes no allowance for possible structural changes in the transmission mechanism as a result of the credit crisis. Economic models are not particularly good at forecasting turning points. That challenge is made all the greater given the disruption to credit channels and the uncertainty surrounding estimates of trend growth. It is possible that, over the short run at least, the desire of firms to rebuild profit margins to repair their balance sheets may, when coupled with the increase in VAT in January, cause inflation to remain higher for longer.
Notwithstanding these risks and uncertainties, we retain our central forecast that UK inflation is likely to fall over the coming years. Our latest inflation projections are shown in chart d. Headline CPI inflation is forecast to drop to around 2.6% by the end of the year and to remain around this level through 2011, as the new VAT increase impacts, before dropping back below 2% from early 2012.
The annual RPI is also expected to slow sharply. Our RPI forecast builds on our CPI profile, but takes into account the expected profile for house prices and mortgage interest payments. Although we expect the inflation environment to weaken, mortgage interest payments are likely to rise modestly next year as the MPC seeks to reverse some of the insurance easing put in place during the credit crisis. While this should put upward pressure on the RPI, this is likely to be overshadowed by relatively weak house price growth and a general weakening of price pressures elsewhere. As such, we expect RPI to fall towards 2% over the medium term.
