Disappointing February figures heighten concerns over “sticky” inflation
First the good news: UK inflation as measured by the annual rate of change in the consumer prices index continued to fall in February. However, the bad news was that it was higher than expected at 3.4%, down from 3.6% in January. Even so, as this compares with a peak of 5.2% as recently as September, the over-riding conclusion remains that the underlying trend in inflation remains firmly downward. Indeed, the headline rate is now at a 15 month low.
Nevertheless, and despite the fact that the “miss” relative to market expectations was only 0.1 percentage points, a number of commentators have already suggested that underlying inflationary pressures are still not under control. This is nonsense. All of the factors that have been putting upward pressure on the annual inflation rate over the previous 12 months—energy, food, alcohol and tobacco—made either a neutral or a negative contribution to the change in the annual rate between January and February. However, because of the recent spike up in energy prices, the negative effect on the annual rate was not as large as had been expected. Whilst admittedly annoying from a forecasting perspective, this does not mean that we should necessarily expect inflation to carry on disappointing through the remainder of the year and into 2013.
It is important to understand that measured inflation is made up of two distinct parts: First, domestically generated inflation as determined by the rate of growth in the quantity of money and which manifests itself in wage inflation; and second, external factors such as oil and commodity prices. The key difference between the two is that whereas we can reasonably expect the central bank, through its monetary policy actions, to influence the former, it can do precious little about the latter. Consequently, when inflation deviates away from target because of such external factors, the only way of forcing inflation back towards target in the short term would be to pursue an even tighter monetary policy regime aimed specifically at further depressing underlying domestic activity. And given that over the past year or so economic activity has largely “flat-lined” (to use an expression popular amongst Opposition politicians) this would have inevitably meant an even weaker (and in all likelihood negative) period of economic growth.
This is precisely the choice that has been facing the MPC over the past 12-18 months. Underlying inflationary pressures are weak and getting weaker as we speak, with average weekly earnings across the whole of the economy in the three months to January up just 1.4% compared with the same period a year ago. However, if the oil price stays where it is until the end of the year, headline inflation is likely to remain above 2% come December. For the reasons outlined above, this will not be a failure of monetary policy. True, the cost of living will have increased by more than expected, but unless energy prices continue to rise at—and this is important—an accelerating rate, eventually, barring a sudden surge in domestically generated inflation, the headline rate will fall back beneath 2% in the following 12 month period.
The key question therefore is what is going to happen to underlying or domestically generated inflation. There is one school of thought that simply sees persistently above target headline inflation by itself as being a sufficient condition for pushing up core inflation, via its effects on inflation expectations and hence wage settlements. In the UK in recent years the most vociferous proponent of this view has been former MPC member, Dr Andrew Sentance, but it was also the primary driver behind the ECB’s misguided decision last year to increase its policy rate on two occasions under Jean-Claude Trichet. Suffice it to say there has been no such follow through from high headline inflation into the underlying measures. Consequently, as the one-off factors driving inflation higher last year have either reversed, not been repeated or have simply dropped out of the annual comparison, headline inflation has fallen sharply. This has come as little surprise to us as the main driver of inflation in our model is the extent to which the economy is operating above or beneath its productive potential. With real GDP at the end of 2011 more than 10% beneath the level that would have prevailed had the economy remained on its pre-recession path, it is difficult to see how the “output gap” can currently be anything other than deep in negative territory. We cannot know with any precision what the exact monthly profile will be, but we remain convinced, barring an explosion of growth on an unprecedented scale, that headline CPI inflation will be below 2% in 12 months’ time. Whether this happens between now and the end of 2012 is neither here nor there. Despite the likely ongoing upward pressure from energy prices, the biggest challenge facing the MPC will be preventing inflation from falling too low over the medium term.
20th March 2012
John Clarke - CIO