Focus on UK inflation

The UK Consumer Price Index (CPI) inflation rate fell by five-tenths to 3.0%, this month, with much of the decline driven by Easter timing effects. The biggest miss against most analysts’ forecasts was in the (duty-affected) alcohol and tobacco component. The fall in core inflation to 2.0% was in line with most forecasts, and on consensus it is expected to rise next month.

Looking forward, we can expect inflation to decline more significantly in the third quarter, as large rises in energy prices drop out of the annual comparison. However, we can also expect CPI inflation to end 2012 above the 2% year on year target and to remain above the MPC’s 2% target in 2013.

Downside risks to this expectation would be lower commodity prices and the stronger pound (which makes the price of imported goods less). In reverse, even if there is a modest decline in Brent oil prices over the forecast horizon, in line with futures prices, depreciation in the value of the pound would at least partially offset the impact of this on inflation and more generally depreciation of the pound, against the dollar in particular, could fuel upside risks to inflation through higher import prices.

Interestingly, the rate of RPI inflation declined by only one-tenth compared to five-tenths on the CPI measure. Much of this seems to be down to lower inflation in air and sea fares (Easter-timing effects), where these components have heavier weights in CPI, and also to the duty-affected rise in petrol/diesel prices (heavier weight in RPI). Hence, we can expect that the wedge will decline in May.

It may well be that the Bank of England’s Monetary Policy Committee (MPC) is too optimistic on the medium-term outlook for inflation and that there is more to be concerned about on the outlook for underlying domestic inflationary pressure than it seems to have incorporated into its central case.

If this is the case we could see hikes in the Official Rate from mid 2013, although we do not expect any tightening in monetary policy until mid-2013. Even then, we expect the path of tightening to be cautious and not to amount to very much. In addition, given the downbeat outlook for the economy in the first half, the cautious Inflation Report press conference and the risk of a deterioration in Euroland, for the next few months, further Quantitative Easing (QE) is not ‘off the table’.

Underpinning this set of expectations is the prospect that growth in the economy is negative for the first half, with a gradual recovery in the second half, helped temporarily by the Olympics and a real incomes boost from lower inflation, supported by the impact of stimulatory monetary policy. Nevertheless, this leaves us expecting about 0.5% growth for UK GDP in 2012, with downside risks from developments in Euroland. Looking further ahead, to 2013, we think that there are more grounds for optimism, and we expect 1.8% GDP growth. On the subject of the Olympics, this could lead to more (temporary) upward pressure on inflation than the modest effects generally expected.

If the growth outlook were to deteriorate again, the risks to inflation would be to the downside, particularly assuming that global commodity prices would also decline further. This could lead to large downward revisions to 2012 inflation forecasts. In contrast, assuming that inflation expectations are at least partly backward-looking, then the prolonged period of above-target inflation could raise the risk of higher inflation expectations. Earnings growth remains particularly weak, and there are upside risks given the long squeeze on household real incomes and the pressure that can build once confidence in the recovery increases. Recent pay settlements data from Incomes Data Services showed a consolidation of basic pay settlements at the 3% mark (2.5% this time last year).

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla