Why is UK inflation so sticky?

This may seem like an odd question to ask in the eye of the worst recession in several generations, and with current headline inflation at 1.8 per cent. However, this is a serious point. UK inflation has exceeded expectations in eight of the last 12 months and has confounded both the market and the Bank of England (BoE). If inflation remains stubbornly high now, given the depth of the downturn and the weakness in commodity prices, then what kind of inflationary backdrop will we face if and when the economy stabilises? Are we about to face that unpleasant combination of tightening monetary policy and weak growth whilst the UK purges itself once again of its inflationary tendencies?

Not a Global Phenomenon

Chart 1 compares headline inflation of the UK, US and the euro zone and shows clearly that inflation has over the last year been notably stickier in the UK than elsewhere.



As comparisons with other economies show, this stickiness of inflation is not a global phenomenon nor is it simply that the countries with the weakest currencies have imported the most inflation. If that were the case, then – of the three economies in Chart 1 – Europe would be leading the race to the disinflationary bottom. So is UK inflation genuinely stickier than inflation elsewhere, as the markets assume, or does inflation in the UK just need a little more patience, as is the BoE's view? The jury is still out on the forecasting ability of both the markets and the BoE, since both have overestimated the path of the UK consumer price index (CPI), which remains 0.5 percentage points above where the BoE thought it would be now, using their November 2008 inflation report.

Why Stickiness Matters

As the economy stabilises, we need to look at the characteristics of the UK inflation data and ask the question about the CPI profile. This analysis is not only important to understand the stickiness of UK inflation, but also has significant consequences for the speed with which the BoE withdraws the monetary stimulus (which is in itself a hard enough job irrespective of the short-term CPI profile). Of course, the BoE should focus on where inflation will be two years rather than six months out. However, if there remains an upward bias to the short-term inflation data, this will necessitate an increase in the inflation forecast two years out at some point. That in turn would bring forward the timing of any tightening in monetary policy and thus increase the risk that the BoE tightens prematurely. The stakes are indeed high; let's hope there is good news to be found in the CPI profile – and thankfully, we think there is.

Looking at the Core

The first interesting point is that while headline inflation remains somewhat out of line with other major developed economies, UK inflation is at remarkably similar levels to the U.S. and Europe at the core level. Crucially, it is below 2 per cent and exhibits neither deflationary tendencies nor inflationary tendencies – goldilocks? Maybe not, but it looks reassuring.



So what's the difference between headline CPI and the core measure, and can the headline number remain irritatingly above the core? The difference between the two measures is that core CPI excludes the volatile food and energy components which can distort the headline number. The idea behind looking at the core is that it gives you an idea of the underlying trends in goods and services without being dominated by commodity prices which tend to move more violently with the ebb and flow of the wholesale markets. That is not to say that the headline measure is irrelevant. For a start, it is the measure that the BoE targets, and secondly the UK is a relatively small, open economy which is affected by the performance of the global economy. In that commodity prices are a good bellwether for global inflationary pressures, headline CPI matters.

With food and energy prices the main difference between headline and core CPI, why are food and energy prices so much stickier in the UK than elsewhere? Energy prices are relatively straightforward. Whilst petrol prices adjust in real time to changes in the oil price, utility bills tend to lag wholesale energy prices by six to 12 months. With commodity prices having come down and utility prices still falling, this should provide some welcome news. Similarly, food prices have remained stubbornly high, and while part of this relates to the weakness of the pound sterling, again there should be good news on the way. Cumulatively, these two factors will mean that headline CPI is likely to be at or below 1.5 per cent by the end of the third quarter of 2009.

Pound and Services Bring More Good News

Indeed, the short-term inflation dynamics look like they will finally bring headline CPI comfortably below target. But what of the longer-term dynamics? Is the weakness of the pound likely to create a big inflationary headache, or is the BoE indeed right to view the inflationary backdrop as altogether more benign?

Firstly, it is undoubtedly the case that goods price inflation is sensitive to changes in the exchange rate. Excluding food and energy, we can clearly see a relationship between goods prices and sterling, just as we can with food prices. If the currency were to suffer another sharp downdraft, UK CPI projections would be vulnerable. However, with sterling having stabilised and indeed rallied in the last three months, it looks like we may well be approaching the peak of the currency-induced inflationary impulse. In that case we should be wary of the influence of the pound on the CPI basket but not necessarily afraid of it.

Secondly and more fundamentally, the question arises whether – in a world where goods price deflation will be less prevalent than in the last decade – service sector inflation can ease sufficiently to ensure the 2 per cent inflation target is achievable. Here again we expect to hear good news in the coming months. Services inflation is correlated to the level of activity in the service sector but even more closely with the level of earnings growth in the service sector. With many parts of the labour market exhibiting higher degrees of flexibility than in the past, it seems perfectly reasonable to expect service sector inflation to ease in the quarters ahead.

Bottom Line

Whilst there have been some oddities that have left many forecasters perplexed by the stickiness of the UK inflation, there does not appear to be some hidden inflationary genie that has been let out of the bottle. The BoE is in our view right to caution that the bigger risk remains a sluggish recovery and it is right to stick to the view that inflation is not currently a cause for concern. We are going through the most severe downturn for several generations; let's make sure we get out of the downturn first before getting preoccupied with any inflationary risk. In time that debate will come but for now the BoE would do well to leave monetary policy loose, stabilise the economy and make sure that we avoid any premature policy tightening. And this means rates are likely to be on hold well into 2010. As a consequence, the 200 basis point increase the markets are pricing in for the Bank Rate in 2010 seem overly pessimistic. This currently makes the front end of the UK bond market good value.

Mike Amey is an executive vice president and a portfolio manager in PIMCO's London office responsible for sterling portfolios.

© Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.