14 Feb 2017

Inflation headed towards target…and then above…

Philip Shaw

Chief Economist

The UK CPI inflation rate climbed again in January reaching 1.8% from 1.6% in December, in line with the Investec forecast, though a touch softer than the 1.9% market consensus.

  • This was the firmest inflation rate since June 2014. Core inflation, stripping out volatile food and fuel components, held steady at 1.6%, whilst the broad consensus had been for 1.7% (Investec 1.6%). At 1.8% the headline inflation rate is now within touching distance of the Bank of England’s 2% target; we expect it to surpass it soon.

  • Note that in general, aside from a sizeable upward influence from the transport category which contributed 0.3ppts to the step up in the 12 month inflation rate, positive momentum was relatively contained across the other major categories, bearing in mind that factory gate inflation is rapidly picking up pace. The main driver of the positive pressure from the transport category was a step up in motor fuel prices which rose by 3.4% month to month (reflecting the sharp rise in oil prices since November) whereas they fell by 2.6% m/m in January last year. The ‘clothing and footwear’ category was the main downward influence knocking nearly 0.1ppts off the 12-month inflation rate.

  • We continue to expect inflation to climb further and to surpass the 3% mark later this year. At the input price level the annual rate of price rises is now a whopping 20.5% (consensus 18.5%, Investec forecast 18.8%); this is the biggest annual rise in input prices since 2008. At the factory gate, price inflation remains a little less buoyant but is still heading upwards rapidly having reached 3.5% y/y in January, its firmest reading since 2011. Note also that January’s month to month rise in output price inflation was double the 0.3% consensus at 0.6% (Investec forecast 0.5%).

  • One open question is the extent to which this level of factory gate inflation is passed through to headline consumer prices, and how quickly too; some firms may decide that the temporary nature of the input price squeeze favours a limited approach to price adjustments and that they bear a sizeable share of the burden. However even if some of the squeeze is not passed through to consumers, the direction of trend for consumer prices is clearly upwards, reinforcing our view that there is a sizeable increase in CPI inflation to come.

  • Over recent months one major force responsible for the rising inflation rate, which is up from a low of -0.1% in September and October 2015, has been the drag from soggy energy prices ‘dropping out’ of the year over year calculation. However as we move forwards we see the effect of post-Brexit falls in sterling on imported inflation feeding through more significantly. Meanwhile, with the economy continuing to run at close to full capacity, in our view, there will be little relief for domestic inflationary pressures which may also build further.

  • The Bank of England, in its recent February Inflation Report, appeared content to look through growing inflation pressures and maintain a close to neutral policy stance; on its own forecasts the Bank saw inflation peak a bit below our own projection seeing 2.75% in Q2 2018. However the Bank is maintaining a close watching brief on pay growth in particular, for signs that domestically generated inflation could provide a more persistent upward influence on inflation that warrants more of a tightening bias for monetary policy. We don’t know the Bank’s exact tolerance level here, but clearly this is worth watching closely, with the latest average earnings numbers due tomorrow (15 February). In the three months to November pay growth had already reached 2.8% y/y.