The sterling squeeze
28 March 2017
UK inflation has risen above the Bank of England’s (BoE) target for the first time since December 2013, with headline price growth up to 2.3% year-on-year (y/y) in February. There are a couple of forces driving price growth rapidly higher. First, we are seeing energy prices swing from a disinflationary to an inflationary force. This component of the consumer price index was up by 8.9% y/y in February, in stark contrast to a 5.5% y/y decline this time last year. This reflects large swings in global commodity prices, which are pushing inflation higher across a range of economies. Second, the depreciation in sterling is adding a significant idiosyncratic impetus to this rise. Indeed, over recent months we have seen a clear pick-up in those components with a higher import content (see Chart 2). For example, non-energy industrial good price inflation is currently at 0.8% y/y (prev: 0.1% y/y) and has now accelerated by two percentage points (pps) since August last year. Conversely, services price inflation (which typically has a lower import intensity) has been broadly unchanged over this period.
Energy price inflation is likely to have peaked in February, as the base effects from low oil prices in 2016 fade. This implies that the 0.4 pps that this component is currently contributing to headline inflation rates is set to slowly diminish over coming months. However, the sterling effect will continue to push aggregate inflation higher. The extent of the exchange rate pass-through to domestic prices is difficult to predict with precision. We have modelled this dynamic and found that the recent depreciation should raise the level of prices by 2.5-3.5pps over three-four years, broadly consistent with the wider literature. The speed of the acceleration in inflation over recent months might suggest that we are set to see a quicker or larger pass through than we are currently factoring in. However, given the volatility around monthly price data we prefer to wait and see how inflation evolves in March before changing our current forecasts for CPI to average 2.6% this year and 2.5% next.
The rise in inflation has interesting implications for the BoE. First, it confirms that the anticipated squeeze in real incomes is taking place. If we deflate average weekly earnings by the Consumer Price Index then these have fallen from 1.8% on the eve of the referendum to 0.3% at the start of 2017 (see Chart 3). The critical question for policy setters is: how will this affect consumption – will households lower their savings to make up for lower income, or will they buy less? Until this question is addressed the Bank will be increasingly uncomfortable about the implicit trade-off that its current policy settings assume between expected lower growth and higher inflation. Especially since price growth is accelerating even more quickly than the BoE had expected in its February inflation report. Considering that in March some MPC members expressed that it would take little further upside news on growth and inflation to change their stance, we could see more dissent at the next meeting in May. This is unlikely to be large enough to build a majority in favour of immediate rate hikes, with most members seemingly still suitably concerned over the outlook this year and next to keep policy highly accommodative. However, this majority will come if the economy does not show clear signs of slowing over coming months and quarters.
James McCann, UK/Europe Economist