Economic and market briefing: UK Inflation

It may well be that the September UK CPI reading (at 2.2% year on year) turns out to be the low point for inflation over the coming year, and there are two key factors that will push inflation up over the next six months – introduction of tuition fees in October which will likely increase the yearly inflation rate by around 0.2% to 0.3%, and energy inflation which will likely be pushed up in October and December, given recent announcements of price increases by major UK suppliers, and this will probably add around 0.4% to annual CPI.

In addition, there is some risk of higher UK food prices, reflecting poor harvests this summer. However, to the extent that global food prices remain subdued the impact on inflation may be muted.

Despite the upside risk to underlying inflation, those who are invested in assets linked to RPI should be aware of the associated downside risks due to the consultation on the formula effect.

The September inflation figures were broadly in line with expectations, with no significant surprises in composition. The main upside in seasonally adjusted terms came from transport, and this may reflect the pattern of demand around the time of the Olympics. The main downside in seasonally adjusted terms came from education, perhaps due to pricing pressures surrounding the introduction of university tuition fees in October.

Around +30bps of the monthly change in inflation in October alone will be due to the non-core factors of tuition fees and electricity and gas price hikes. The tuition fee component should also increase the CPI index in October 2013 and 2014 as each new year of students experiences higher tuition fees. However, we can expect this effect to decline over time

With gas price increases announced by several major electricity and gas suppliers for October and November, we can expect other providers to follow suit in coming weeks/months. If the current pattern of price rises is used by the remaining firms, then electricity and gas could push up on the CPI inflation by around 0.4% by end year. Excluding the October number, most of the price rises announced thus far are likely to fall into the December index (even though they take place in November) due to their position within the month.

With regard to food inflation, despite weak harvests domestically, substantial upside risks remain subdued. Global food pricing suggests that there are limited risks to UK food inflation over the next six months but there is some evidence of rising domestic cereal prices and this could provide marginal inflationary pressure in the medium term.

A key driver of medium-term UK inflation prospects are Core goods (non-energy industrial goods), which account for about 30% of the UK inflation basket. Importantly, core goods have also experienced a significant shift in inflation rates pre- and post-2008. The average inflation rate was -2.2% in 2000-07, but 1.5% post-2010. Clearly, a key question for the medium-term inflation outlook is whether core goods inflation will revert to previous levels or be maintained at current, relatively high, inflation rates.

In thinking this through, there are two key potential drivers behind the recent rise. First, part of the increase in core goods inflation was due to the depreciation of the pound in 2008. Since the UK imports substantial numbers of manufactured products, a weaker pound feeds through into higher core goods inflation rates. The implication for future inflation rates is that as this one-off price shock fades, inflation rates could revert to their previous levels. Indeed, data suggest that short-term core goods momentum is actually negative, although to some extent this may be a function of the appreciation of the pound over previous months.

On the other hand, it could be that core goods inflation was pushed downwards in the pre-2008 period due to the increasing availability of cheaper manufactured products from abroad and since 2008, the long-term gap between producer prices and core goods has narrowed substantially (by around 2%). If that narrowing of the gap persists, core goods inflation of around 0.3% would be consistent with current producer price momentum. This is roughly the same rate experienced by France and Germany prior to 2008, since when rates have increased. To the extent that the gap between consumer price inflation and producer price inflation remains limited in coming years, in part due to the lack of new supply of cheaper manufactured products, we would expect core goods inflation to remain strong, and core inflation of 0.6% or so in the medium-term seems feasible.

It is unclear which of the above scenarios is likely to dominate and in all probability it will be a blend of factors that drives the rate. Core goods inflation pushed higher in the 2009/10 period by the depreciation of sterling but this will have dissipated and since June 2011, the average annualized 6m/6m core goods inflation rate has been 1%. It seems likely that core goods prices will grow at somewhere near, though perhaps slightly below, this rate in the medium term.

Against this backcloth, we should expect the Bank of England’s Monetary Policy Committee to maintain very easy policy for the foreseeable future.

UK CPI – annual averages %

	Total	Food	Alcohol& Tobacco	Energy	Core CPI Total	Goods	Services
2010	3.3	3.4	5.5	5.7	2.9	1.9	3.6
2011	4.5	5.5	8.7	12.3	3.2	1.6	4.3
2012	2.8	3.1	5.9	5.4	2.3	0.6	3.5
2013	2.6	2.4	3.9	3.2	2.5	0	4.1
2014	2	2.4	2.4	-0.5	2.3	0	3.9

UK RPI – annual averages %

	Total	Food	Alcohol/ Tobacco	Petrol	Elec	Gas	Housing Depreciation	Council Tax	Mortgage Interest	Core Goods	Core Services	RPI-X
2010	4.6	3.1	4.8	17.5	-2.4	-5.9	6.0	2.0	1.0	4.5	5.3	4.8
2011	5.2	6.0	7.4	15.4	7.3	10.7	-0.9	0.6	3.1	4.1	5.0	5.3
2012	3.2	3.1	4.8	2.4	6.2	11.2	0.5	0.4	2.2	2.7	3.2	3.2
2013	3.3	3	2.5	-0.5	6.5	6.1	1.2	2.4	6.1	2.3	4.7	3.2
2014	3	3.3	1	-1.1	0	0	1.2	0.8	7.3	2.4	5.1	2.9

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