The UK is treading a fine line on inflation

Inflation in the UK appears perfectly placed to spur productivity and wage growth, but two factors pose upside risks that could force the Bank of England to raise rates prematurely.

Inflation in the United Kingdom rose by 0.4 per cent in August in line with expectations to be 1.5 per cent higher over the year. Annual inflation has eased somewhat over the past couple of months, which if maintained will allow the Bank of England to delay a decision on rates until it is happier with the combination of wage and productivity growth.

Inflation was driven by clothing and footwear and transport prices, which between them accounted for three-quarters of inflation during August. This more than offset a modest decline in food prices, while petrol prices eased further.

As a result, core inflation (which removes volatile items such as food and energy) has been considerably stronger than headline inflation over the past six months. Core inflation rose by 1.9 per cent over the year to August, slightly below the BoE’s upper target for annual inflation of 2 per cent.

For now inflation almost seems perfectly placed, sufficiently high to encourage activity but not so high that it requires a premature rate hike. The BoE would be more than happy if inflation stays at this level for a prolonged period, which would give wages and productivity a chance to improve before the bank begins to tighten.

But the risks to inflation for the UK largely sit to the upside and primarily centre on two issues: why inflation has eased and the exchange rate.

As noted above, headline inflation is being dragged down by volatile factors that could easily swing the other way. For example, fuel prices have declined by 5.7 per cent over the year to August. If petrol prices stabilise -- not increase, but just remain at their current level -- that would add around 0.3 percentage points to headline inflation over the next year.

In their August inflation report, the BoE noted that “global energy prices remain a key risk, especially if they become more sensitive to geopolitical events”. It remains to be seen whether energy prices become more sensitive but conditions have certainly deteriorated since the publication of that report, with the US and her allies heading back to Iraq.

The extent to which markets price in a geopolitical risk premium will largely determine whether UK inflation remains contained. So far geopolitical risks have largely been ignored but the risks to the oil price certainly appear to be on the upside.

The interplay between oil prices and the sterling will also be important. The UK exchange rate remains elevated, largely reflecting the perceived strength of the UK economy compared with Europe and its other trading partners.

The BoE would prefer a lower sterling to foster greater investment and export growth, but that appears unlikely given the relative weakness in Europe. Potentially, the end of the Fed’s taper could put some downward pressure on the sterling but surely the taper has already been priced into markets.

For now I expect the sterling to remain at an elevated level, although it could come under pressure should the Yes vote win out in this week's Scottish referendum. If there is a No result, it could potentially head higher if the eurozone suffers its third recession, placing some downward pressure on the inflation rate over the next year.

The worst case scenario is one where oil prices rise and the sterling depreciates. Would the BoE raise rates prematurely? Two factors suggest that they shouldn’t: wages and productivity growth remain disappointing and central banks have a poor record of reining in inflation that is sourced from overseas.

Overall the BoE appears likely to tighten rates next year but they won’t hesitate to leave rates at 0.5 per cent if inflation remains under their 2 per cent target. Oil prices and the sterling are the main risks for inflation but oil prices have yet to respond to heightened geopolitical risks.

The sterling obviously poses a considerable risk but for now should continue to weigh on domestic inflation. As for wages, they could potentially break out -- particularly if the labour market continues to improve -- but so far appear to be well contained.