UK: Back to deflation – the bottom for now

• UK was back in deflation in September as CPI inflation declined to -0.1% y/y, from 0.0% y/y in August (Danske Bank 0.0% y/y, consensus 0.0%). Core inflation was unchanged at 1.0% y/y in September (Danske Bank: 1.1% y/y, consensus: 1.1% y/y).

• We have for some time argued that Bank of England (BoE)’s focus has shifted back to inflation in the wake of lower oil prices and stronger GBP. Although we expected an unchanged print in September, we have on several occasions mentioned that one could not rule out that inflation could turn negative again. This is one major reason why the BoE has been relatively dovish lately as it, in our view, wants to see CPI inflation move higher before hiking. Unless we see a further drop in commodity prices, we think inflation hit the bottom in September, as we estimate CPI inflation will move slightly higher in the coming months before picking up close to 1% in January 2016 when the base effects from the drop in oil prices in H2 2014 begin to drop out.

• The expected pick-up in inflation early next year should reduce concerns among MPC members and thus we continue to believe the BoE will hike in Q1 16, probably in February. The tighter labour market and accelerating wage growth put pressure on the BoE.

• Looking at the details, the drop in headline inflation was mainly due to ‘clothing and footwear’ and fuels which both pushed the inflation rate down by 0.1pp. ‘Clothing and footwear’ prices were 0.6% lower in September this year compared to September last year. This is a clear sign that the strong GBP weighs on inflation through lower import prices as clothing and footwear is mainly imported. Fuel prices were 15% below their levels in September last year. Both diesel and gasoline prices have stabilised in October as suggested by the recent movements in the Brent oil price and thus fuel prices are so far unlikely to push inflation further down in October.

• On the other hand ‘travel & transport services’ pushed the inflation up by 0.1pp. As a result, services inflation increased to 2.5% y/y in September from 2.3% y/y in August and is now at the highest level since October last year. The annual growth rates in services prices are somewhat volatile but the increase indicates that domestically generated prices are increasing. Although services inflation is above the Bank of England’s 2%-target, services inflation is still low from an historical perspective.

• Some British energy companies have announced energy bill price cuts beginning from late September/early October which represent a downside risk to the CPI inflation print in October.

• Focus is on wage growth tomorrow when the UK labour market report is due. We expect that the average weekly earnings excluding bonus (3M avg.) rose to 3.0% in August from 2.9% y/y in July. Going forward, we expect wage inflation to accelerate further as the labour market continues to tighten.

Back to deflation

Drop in fuel prices pushed inflation further down in September. But fuel prices have stabilised in October so far

Strong GBP continues to weigh on inflation through lower import prices

Combination of very low inflation and increasing nominal wage growth implies high positive real wage growth

Falling commodity prices and lower import prices explain very low inflation