Pantheon Macroeconomics

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20th Sep 2018 07:25News

Q: Do August’s U.K. CPI data point to an ingrained inflation problem?

A: We are confident that the rise in CPI inflation to 2.7% in August, from 2.5% in July, is just a blip.  Over half of the increase was driven by two sectors—transport services and recreational goods—which are volatile.  Transport prices are sensitive to the day of the month the ONS collects its data, while recreational goods prices spike temporarily when major new computer games are released.

Past movements in trade-weighted sterling continue to suggest that core goods inflation will fall to zero by the end of this year, from 1.5% in August.  This decline would subtract a hefty 0.47pp from the headline rate.  Import price data confirm that a further sharp fall in core goods inflation is imminent.

Speculation has grown that food inflation is about to soar, because the hotter-than-usual summer has depressed crop yields. But farm gate inflation eased to a two-year low of just 1.2% in July, while import price inflation has been slightly negative over the last three months. Food shop prices also lag producer and import prices by around six months. Accordingly, we still see scope for food inflation to fall from August’s 2.5% rate over the coming months.

Running in the opposite direction, the contribution of electricity and natural gas prices to inflation likely will rise by about 0.10pp over the next four months, as suppliers push through a second round of price hikes.  But Ofgem is set to introduce a cap on standard variable tariffs by the end of this year, which should reduce the electricity and natural gas indices by nearly 6%, subtracting 0.20pp from the headline rate of inflation.  The electricity and natural gas CPI indexes are derived solely from SVT data, even though only around half of households are on these tariffs.

Meanwhile, the surge in goods prices over the last 18 months has distracted from continued weakness in services inflation.  Our measure of “underlying” services inflation, which strips out transport services, education costs and rents from the main services index, rose only to 2.5% in August, from 2.4% in July.  It is a long way below the 3¼% rate that it will need to hit next year, once core goods inflation has dropped to zero, in order to prevent core inflation from drifting below the 2% target.  We see no signs that services inflation is about to rise materially; indeed, the net balance of services firms intending to raise prices over the next three months fell to a 14-month low in August, according to the EC.  Wage growth has picked up, but the recent deterioration in pay settlements and measures of employment intentions casts doubt on whether the improvement can be sustained.

Accordingly, CPI inflation still is on track to fall steadily, reaching 2.2% by the end of this year and 2% in the spring.  It should continue to fall, averaging just 1.7% in the second half of 2019, provided sterling and oil prices are stable over the coming months. Below-target inflation won’t rule out further increases in Bank Rate next year, but it will enable the MPC to take its time.

Samuel Tombs, Chief U.K. Economist

Pantheon Macroeconomics

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