External lowflationary forces continue to keep UK inflation significantly weak, while domestically generated inflation appears to have been building up recently, but is still too weak to offset the effect of cheap energy and imports.
The median estimate suggests UK CPI inflation remained unchanged at 0% in July. The core CPI, a less volatile gauge stripped of energy and food prices, is estimated to have stayed at 0.8% - the lowest level in fourteen years. The UK's Office for National Statistics (ONS) is releasing July figures on Tuesday this week.
Despite expectations pointing to no change in inflation, notable falls in oil and petrol prices in July this year, compared with the same month a year ago, suggest inflation may have slipped back below zero again, easing pressure on the Bank of England (BoE) to begin returning the base interest rate slowly towards more normal levels.
Falling petrol prices
According to the AA Fuel Report, the UK national average price of unleaded petrol in July this year was as much as 11% below the average petrol price back in July 2014. And the fact that transport costs in July last year were the main upward driver to the annual CPI change, we can expect marked downward pressure from this segment on this year's July inflation rate.
The price of Brent crude fell between June and July this year by 6.3%, and was a massive 40% below the level seen in July last year. The Bank of England (BoE) reiterated in its August forecast that as much as three quarters of the downward deviation of CPI inflation from the 2% target has come from the volatile prices of energy and food. Those external factors, combined with subdued domestically-generated inflation, have been keeping the overall CPI below the target since December 2013.
The BoE consequently struck a more dovish tone again in its August Inflation Report, revising down the near-term inflation outlook on the back of strong downward external pressures stemming from weak oil prices and sterling appreciation.
"In light of the reduction in oil prices and appreciation of sterling over the past three months, it appeared that the increase in inflation over the following year would be more gradual than had previously been supposed," the BoE's Monetary Policy Committee (MPC) minutes read in August.
Sterling pass-through hard to evaluate, but critical
Writing in The Telegraph on Sunday last week, MPC rate-setter Kristin Forbes said the pass-through from previous sterling appreciation could be faster and softer than estimated, but added that "risks from sterling’s recent movements are the hardest to evaluate, but critical"
"Sterling’s appreciation from early 2013 to mid-2014 did not reduce import prices by as much as has historically occurred, thereby causing less drag to inflation. If this lower degree of pass-through continues, or any pass-through occurs faster than in the past, inflation could recover faster than we forecast," Forbes wrote.
She also warned that "maintaining interest rates at the current low levels during an expansion risks creating distortions." Forbes has been voting for no change to rates since she joined the MPC in July 2014.
Relative to the May Inflation Report, the BoE lowered short-term inflation forecast almost by half to project an inflation rate of only 0.3% on a median basis by the end of 2015, then rising slowly to 1.5% at the end of 2016, reaching the 2% target in the third quarter of 2017. The lower near-term inflation outlook implies gradual interest rate increases, confirming current market expectations of a February lift-off, but with the risk of a delay to May remaining plausible, if weak inflation persists.
Shop price deflation, as measured by the British Retail Consortium (BRC), also adds to this downward trend. In its July survey, the BRC estimated that overall shop price deflation sank deeper to 1.4% in July, lower than the 1.3% fall in June.
Wage growth strengthens
Regarding domestically-generated inflationary pressures, such as wages, those have shown tentative signs of building up, but still remain too weak to offset strong external lowflationary forces.
According to the latest labor market data, regular wages - those showing a more underlying growth stripped of volatile bonus payments - continued to increase by 2.8% over the quarter to June, which was the highest rate of growth since 2009. Total earnings, including bonuses, dropped unexpectedly to 2.4% in June from 3.2% a month before, but this sudden drop was mainly due to the fact that the bonus season was over at the time of June's data collection.
For now, record-low inflation, combined with rising wages, offers higher real income to households, who in turn feel less pressure on their budgets after years of above-target inflation and low wages. But the risk that inflation overshoots the target again remains highly possible if the BoE continues to sit on rates for longer than necessary.
"Because this is not just about inflation, as you know, over the course of the next few months, but inflation for the medium term, so people don't have to worry about inflation, so people can enjoy the dividend, if you will, of lower petrol prices, lower food prices today, without worrying about a payback in the medium term," Governor Mark Carney said during the August Inflation Report press conference.
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