WISHFUL THINKING ON UK INFLATION
by Peter Warburton and Tom Traill - 15 September 2016
The New Normal crowd has had it their own way for much too long: the notion that grindingly slow economic growth will be accompanied by the long-term sterility of consumer prices has a powerful grip on Bondworld. Throw in the demographic and the technology arguments and they reckon that a future of low or no inflation is a slam dunk.
Then came Brexit and an abrupt 13% depreciation of Sterling. How would the New Normal crowd react? It is no surprise that their instincts are to downplay the inflationary impact of Brexit. They expect headline CPI inflation to rise only moderately over the coming year, as compared to their pre-Brexit baseline, touching 2% at worst and averaging only 1.5% for 2017. They anticipate that the weakness of domestic demand will open up a large output gap and exert disinflationary pressure. They posit weakness in core goods and services prices which will counteract the effects of the stabilisation and partial recovery of the US Dollar oil price, and of the impact of the pronounced drop in Sterling on import prices. Another suggested route to a similar outcome focuses on a very weak pass-through of Sterling depreciation into domestic prices.
Those of us with long memories tend to take a very different view. The UK has been one of the most inflation-prone countries in western Europe over the past 25 years. Our 20th century peak inflation rate of 25% a year was in 1975. We managed double-digit CPI inflation as recently as 1990. The UK is heavily dependent on imports across a wide swathe of manufacturing sectors, susceptible to bouts of money madness and protective of oligopolies in consumer-facing sectors such as megastores and car dealerships. Ripping off the punter is a national sport.
Our latest decomposition of the RPI shows private sector inflation (excluding fuel and light) rebounding over 3%. We prefer the old retail price index for this analysis because it includes housing. The chart confirms that UK inflation remains elevated in comparison to the 1992-2007 period, which Mervyn King termed the NICE (non-inflationary constant expansion) years. The global financial crisis marked the beginning of a new era of erratic and generally higher UK inflation. The crisis weakened the forces of domestic competition and allowed the profitability of the service industries to soar to new heights.
In common with other advanced economies, headline CPI inflation flirted with negative inflation last year under the full force of the energy price collapse. The starting gun on inflation normalisation was fired in May 2016 and overreach of the next 12 months, the bias is to an annual increase. However, it is clear from the forecast profiles of UK consumer price index (CPI) and retail price index (RPI) forecasts for 2017 that there are two distinct camps regarding the evolution of UK inflation.
The New Normal crowd are dismissive of normalisation and Brexit-related pressures. They expect them to be muted and temporary. Others take the view that Sterling import prices will increase materially and that headline CPI inflation will reach over 2.5% next year, maybe even 3%. The remarkable aspect of this divergence is that we can observe already a substantial impact on imported inflation in the July and August producer price inflation data.
Based upon the historical relationship between import inflation and CPI inflation for non-energy industrial goods, headline CPI inflation should move up by 1.5 to 2.0 percentage points from its current 0.6% by mid-2017. For RPI, the implied shift is from 1.9% currently to around 3.5% by mid-2017.
The lowball forecasts suggest a marked degree of profits compression, either for domestic companies (in the first low scenario) or for foreign companies (in the second low scenario). Our sympathies are with the conventional view of inflation pass-through, embodied by the higher estimates. The profile of the output loss from Brexit (if any) is likely to be gradual and cumulative over the next 3 years, not sudden, as inferred by the expectations surveys, meaning that the domestic economy does not suffer an air pocket effect. Without the assumption of an initial post-referendum output and spending slump, there is no justification for a sharp downward price adjustment. UK inflation break-evens – based on RPI – have rallied in anticipation of the changing landscape but by much less than would properly reflect the inflation coming our way.
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