Economic Update: UK Inflation

The latest official headline figure for UK inflation, as measured by the Consumer Price Index (CPI), appears to have peaked. It fell marginally lower from 3.1% in November to 3% in December, the first drop recorded for six months.

This is good news and will give respite to consumers who have been feeling the pinch.  To put this into context, an average basket of goods and services costing £100 in December 2016 has risen to cost £103 last month. The push up in the general level of prices is happening at a time when average wages are growing but not keeping pace with the inflation rate. If inflation slips back and wage growth, currently at 2.5%, picks up spending power will begin to be restored.

The recent upward march of inflation is generally regarded as coinciding with the Brexit referendum result and the decline in the value of the pound. However, from the chart we can see that inflation had started to tick up even before the result was known. The pound had already fallen from its peak level of 1.72 back in July 2014, Brexit just pushed it down faster and further.

It seems probable that price have been pushed up by the improvements in economic activity underway across the UK. Quantitative easing and lower interest rates have also been inflationary. As well as these factors, the fall in sterling has driven inflation higher than expected and perhaps explains the sensational reaction in certain parts of the media.

What is less visible to the general public is that sterling v the dollar has started to creep back up leaving the general level of prices less vulnerable to imported cost pressures.

UK Inflation vs Dollar Strength

Source: Bloomberg, January 2018

With inflation set to ease there should be a positive knock-on effect elsewhere for the UK economy. It may allow consumers to spend more on discretionary items and retailers to sell more goods and services, hire more staff, pay higher wages and reduce the price of goods further down the line. Whilst anticipating the effect of exogenous factors, like the rate of exchange, is challenging, economists seem to be settling on the idea that the effect from sterling depreciation will begin to wane. This is a function of the way costs are passed through as a one-off hit.

In November last year, the Bank of England raised interest rates from 0.25% to 0.5%. Although this was interpreted by some as an attempt to keep inflation under control the main reason was to restore the interest rate level to what it was previously. It was an acknowledgement that the ‘emergency cut’ as it was termed at the time, wasn’t really necessary.

The recent change in direction in CPI, if it persists, should ease the pressure for further interest rate rises in the short to medium term. Keeping rates lower for longer keeps a lid on the costs of financing allowing access to affordable credit which is used to purchase big ticket items like cars and housing.