Inflation back to 0% – but will it stop a rise in rates?

Zero again: ONS’ inflation report

The Office for National Statistics (ONS) reported that Consumer Price Index (CPI) inflation fell back to zero year-on-year in June from 0.1% year-on-year in May, in line with our forecast and the consensus.

The UK’s year-on-year inflation rate has now been below the rate for Euroland (which was 0.2% year-on-year in June) for three months in a row, and this is the longest such run since 2008.

Within the inflation data, the weakness is widespread. Based on an 85-item disaggregated split of the CPI, we can estimate that 52% CPI items have a negative year-on-year inflation rate, and this is only marginally below the record high of 54% recorded in April. 80% of CPI items (a record high) have a year-on-year inflation rate of equal to, or less than, 2% year-on-year, including items with a negative year-on-year rate.

The split shows core inflation (i.e. CPI ex food, drink, tobacco and energy) falling slightly to 0.8% year-on-year in June from 0.9% year-on-year in May, matching the April figure as the lowest since 2001. It highlights the disinflationary effects from the strong pound and weak external prices. In particular, the core goods inflation rate (i.e. goods ex food, drink, energy, tobacco) fell to minus 1.5% year-on-year in June from minus 1.2% year-on-year in May, and is the weakest since 2008-09 (when VAT was cut).

Core goods inflation in the UK is markedly weaker than Euroland’s pace of -0.1% year-on-year, and indeed the decline in core goods prices in the UK is greater than any of other EU15 countries except Greece and Ireland.

Services inflation also is soft (2.1% year-on-year in June) but remains somewhat above the euro area pace (1.3% year-on-year).

Looking ahead, we can expect another couple of months with the headline year-on-year CPI inflation rate close to zero, but then we should expect a slight rise for the September data (published in October) onwards, reflecting base effects from last year’s slide in oil prices.

Based on current data and trends, we can pencil in a forecast for the December 2015 inflation rate of around 0.9% year-on-year.

What’s behind these numbers is that even with the pick-up in UK pay growth, it looks likely that the strong pound and weakness in external costs will keep UK inflation in 2016 well below consensus and MPC forecasts (and also below the target), with CPI inflation in 2016 averaging perhaps less than 1.5% year-on-year.

But we should anticipate that such low inflation may well not stop the Bank of England’s Monetary Policy Committee (MPC) from starting to hike, given signs that labour market slack is shrinking fast. If the labour market continues strong and wage pressures continue to build, we should pencil in the first MPC hike for early 2016. That said, the prospect of continued below-target inflation can be expected to allow the MPC to keep rates relatively low for a while although this view is broadly discounted in the cash markets already.

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

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