Volatility masks Britain's real inflation

Inflation in the UK is at its lowest level since September 2009, but there are good reasons why the Bank of England can remain optimistic.

Inflation in the United Kingdom has taken a turn for the worse and, if it persists, there will be little pressure on the Bank of England to raise rates until later next year. But much of recent weakness relates to volatile and often temporary factors, and suggests that inflation may rebound over the next year.

Inflation in the UK rose by 1.2 per cent over the year to September, surprising market analysts, to be at its lowest level since September 2009. Inflation has eased from 1.5 per cent in August and 1.9 per cent in June.

The result fell well short of the BoE’s annual inflation target of 2 per cent and brings into question recent comments by BoE governor Mark Carney who said in June that a rate hike could “happen sooner than markets currently expect”.

Any pressure on the BoE to raise rates has eased since June and a rate hike in the first half of next year now appears off the table. Yet conditions can change quickly and there is good reason to be optimistic about the UK economy.

Transport price fell sharply in September, largely due to a significant decline in the volatile air and sea transport series. That offset a surge in clothing and footwear prices. Fuel prices continue to fall and are 6 per cent lower over the year, while food prices eased slightly in September and are 1.4 per cent lower over the year.

As a result, core inflation, which removes volatile items such as food and energy, has been considerable stronger than headline inflation over the past six months. Core inflation rose by 1.5 per cent over the year to September (from 1.9 per cent in August) to also be well below the BoE’s target for inflation.

So should markets be concerned? Does this mean that the UK economy is on the slide and rates will remain at the zero lower bound for the foreseeable future?

Not necessarily. To understand why, we need to focus on two central issues: why inflation has eased and the exchange rate.

As noted earlier, headline inflation is being dragged down by volatile factors, such as food and energy, which could easily swing the other way.

For example, fuel prices have declined by 6 per cent over the year to September.  If petrol prices stabilise -- just remain at their current level -- that would add around 0.3 percentage points to headline inflation over the next year.

In its August inflation report, the BoE noted that “global energy prices remain a key risk, particularly if they become more sensitive to geopolitical events”. The extent to which markets price in a geo-political risk premium will go some way to determining whether UK inflation remains contained.

As it stands though, low fuel prices are supporting the UK recovery and employment growth. As a key input for many organisations, low fuel prices are generally good for an economy. But it is also important to remember that they are volatile and can swing wildly from year-to-year, which is why most economists focus on core measures of inflation.

The interplay between oil prices and the sterling will also be important. The UK exchange rate remains elevated, although it has eased recently, 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 I’m not convinced it will get its wish given the ongoing weakness in Europe. Its best bet is a further depreciation against the US dollar, particularly once the Fed completes its asset purchasing program at the end of October.

On the domestic front, wages and productivity remain disappointing and go some way to explaining why inflation remains so subdued. But with the UK labour market continuing to improve, I anticipate that wage pressures will become more pronounced and widespread over the next year. Productivity growth, however, will need to pick-up for the UK recovery to maintain its recent run of strong growth.

Overall, the risks to inflation appear generally on the upside. Oil prices can easily reverse, while domestic wage growth should begin to improve as the labour market recovery persists. The sterling continues to create uncertainty, but I expect a further depreciation against the US dollar. A depreciation against the euro is less likely given the latter’s ongoing troubles.