In February 2013, the Bank of England was predicting the worst inflation/growth trade-off on record. But in May, governor Sir Mervyn King was able to sign off in his final Inflation Report by presenting lower inflation forecasts and an improved outlook for GDP growth. Another good surprise was April annual consumer price inflation falling sharply to 2.4 per cent – the lowest since September 2012.
However, we think this reduction in inflation is merely a blip and expect it to climb again. In contrast to the Bank of England, we do not see inflation falling close to the 2 per cent inflation target by the end of 2014.
First, April’s inflation fall was partly down to an early Easter that brought price increases on services such as travel forward to March. Previous early Easters suggest this effect will be reversed. And the lower petrol prices that also helped to reduce transport costs are unlikely to be sustained too.
Other commodities have also started to rise – or at least stopped falling. Prices of vegetables, hit by very cold weather in early 2013, have risen and home-produced food prices could continue to accelerate even though import-price inflation may have moderated as sterling stabilised. Inflation in food prices has already diverged significantly from other goods’ inflation rates.
Further, there are still some persistent cost pressures in the UK. The rise in gas and electricity prices in early 2013, followed by reports of acute gas shortages, make it likely bills will rise again in the winter.
Central banks around the world are once again leaning towards more monetary easing
Meanwhile, central banks around the world are once again leaning towards more monetary easing, despite fears of the US Federal Reserve tapering asset purchases. The low-inflation environment in much of the rest of the world makes further easing easier to justify, despite concerns over competitive currency depreciation.
While we do not expect the Bank of England to resume asset purchases, if sterling appreciates significantly because of easing elsewhere, new governor Mark Carney could find it easier to adopt a more radical policy if he wants to. By tolerating a degree of currency weakness, the potential disinflationary impact from the exchange rate would be limited.
There are also more structural and longer-term reasons why we think above-target inflation will persist: spare capacity in the UK economy may be less than the government and the Bank assume.
Firms have faced accelerating costs over recent years – especially importers. This squeeze in profit margins has been partly offset by weak nominal wage growth. But UK productivity growth has been weak since the financial crisis, causing unit labour costs to rise.
However, weak productivity growth has persisted for so long that we think much of it must reflect structural problems. That means output cannot rise without stoking inflationary pressures – another reason to think inflation won’t fall back to target in the medium term if policy stays loose.
And one UK-specific reason why we believe inflation will not fall in 2014 concerns housing costs. The rise in house price inflation expected by many because of the government’s Help to Buy scheme and the Bank’s Funding for Lending Scheme has implications for the retail price index because housing – including property prices, mortgage payments, rent, council tax, water, DIY and repairs – now accounts for a record 25.4 per cent of the index. Even small increases in housing costs will thus make larger contributions to RPI inflation.
Finally, there is the big question of what changes to the central-banking and inflation-fighting framework incoming Bank of England governor Mark Carney might bring. We think the Bank of England has already shifted subtly towards a more ‘flexible’ approach to inflation targeting. Higher inflation now thus has less chance of affecting the Bank’s policy outlook in our view.
This research was first published on 3 June 2013.