Further sterling depreciation, and an expected spike in food prices in the case of Brexit, could generate notable upward pressure on consumer prices in Britain.
London - Inflation in Britain has been stuck below the official target of 2% since January 2014 and even dipped into deflationary territory on three occasions over the course of 2015. The largest downward pressured has come from sharp drops in oil and food prices. The pass-through effect on inflation from sterling’s 2013 strong appreciation has also fueled notable disinflationary pressures.
But sterling's foreign exchange rate reversed the trend in late 2014 and its depreciation has been accelerating even more since late 2015, mainly on the back of mounting Brexit concerns and the monetary divergence seen between the Bank of England (BoE) and the US Federal Reserve (Fed).
If the British currency continues this downward trend, which the majority of analysts expect it will ahead of the June 23 EU referendum, more expensive imports could push up on consumer prices in the UK.
BoE's view on sterling
The BoE's monetary policymakers judged during their March monetary meeting that "a significant proportion of the recent decline in sterling reflected uncertainty surrounding the forthcoming referendum on UK membership of the EU."
In a similar fashion, the BoE's Financial Policy Committee (FPC) recently warned that "heightened and prolonged uncertainty has the potential to increase the risk premia investors require on a wider range of UK assets, which could lead to a further depreciation of sterling and affect the cost and availability of financing for a broad range of UK borrowers."
The central bank estimated in March that inflation could reach 1% at the end of this year, but a further decline in the British currency rates could increase upside risk to this outlook, the policymakers also argued.
The BoE rate-setters also argued that much of the expected rise in CPI inflation during 2016 should be driven by a so-called base effect. This means that downward pressure on CPI from cheap petrol or food this year will be softer than it was last year, thus pushing up gently on annual rate of inflation over 2016.
Dearer food
Another factor that could boost inflation is an expected spike in food prices in case Britain opts out of the European common bloc. The annual CPI rate of food prices in UK has been in red over the last twelve months, falling by an average of nearly 3%, and has been among the most significant downward drivers on the overall consumer price index.
In a study commissioned by the UK's National Farmers' Union (NFU), there are two post-Brexit scenarios (out of three), which could result in notably more expensive consumer food prices in the UK.
The first scenario is that the post-Brexit relationship with the EU will be based on 'Free Trade Agreement' (FTA). The second is a so-called 'the World Trade Organisation (WTO) default position.' The study argued that both of those two cases could lead to increased farmgate prices, and more expensive imports due to trade costs and higher tariffs.
"This would be a reverse of the policies that successive British governments have pursued for the past 40 years; it would go against a worldwide trend to more open agricultural trade and would be in contradiction to the stated aims of many of those who advocate that the UK should leave the EU," the NFU said in the report.
The overly confusing post-Brexit scenario in the UK could create a rather asymmetric situation for the central bank. Some would call for more monetary easing to spur growth hit by the UK's exit from the EU, while the above-mentioned upside risks to the inflation outlook would likely keep the BoE cautious about any aggressive easing in order not to significantly overshoot the inflation target in the medium-term.
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