EEF blog

Yesterday’s inflation figures presented some good news for the MPC. CPI came in at a lower-than-expected rate of 3% meaning – for the first time in this Parliament – that the Governor of the Bank of England did not have to write a letter to the Chancellor of the Exchequer.

CPI inflation is now at its lowest level since February 2010, but it remains well above target, and has been for over two years. 

Yet this morning’s MPC minutes hint that increased monetary easing is more likely than an increase in interest rates any time soon. As with last month, all committee members voted to maintain the stock of asset purchases at £325bn with the exception of David Miles, who voted in favour of a £25bn extension to the scheme.

So given the high level of inflation why is more monetary easing on the table?

The UK economy is still weak. As with last week’s Inflation Report, the MPC’s minutes noted the significant risks to growth associated with the economic turmoil in the Eurozone. Similar points were highlighted yesterday, when the IMF released its review of the UK policy mix. In fact, the IMF argued that weak growth and limited underlying inflationary pressure suggest further monetary easing is required. 

Our own forecasts suggest that growth is likely to be weak, and inflation should fall back to target early next year. However, we now expect inflation to return to target later than we previously forecast, due to the increased outlook for oil and commodity prices: upside risks to inflation remain.

As King pointed out during the press release for the Inflation Report, the amount of spare capacity in the economy is difficult to predict, and will be affected by tight credit conditions and economic uncertainty, yet it is precisely this spare capacity that is expected to keep domestic price pressures under control.

Other upside risks to inflation noted in today’s minutes:

-         developments in global prices, such as for commodities

-         growth in domestic costs

-         degree to which companies seek to restore margins

The minutes also noted some downwards risk to inflation:

-         weak economic activity might result in inflation falling materially below 2% in the medium term

-         demand growth might be weaker than expected

Today’s producer prices data reflect what surveys such as the PMI have been pointing to for the last few months: input price rises are starting to ease. 

Although prices were still up by over 14% in the year to October, this was the lowest annual increase since December 2010. What is more, between September and October prices actually fell back a little, mainly reflecting price falls in crude oil, imported metals and home produced food.

This will provide some comfort for the Monetary Policy Committee, which has argued that consistently above-target inflation has been largely caused by external pressures that should start to abate in the next twelve months.

Based on this view, the MPC announced yesterday that it would keep the base rate on hold at its record-low level of 0.5% and continue to add to its stock of asset purchases up to a value of £275bn over the next three months. This loose monetary policy also reflects the MPC’s belief that demand – at home and abroad – will be so weak as to risk inflation falling below target in the medium term.

But these arguments are disarmingly similar to those we have heard from the MPC from some time. And inflation has remained high. In December inflation will have been above the MPC’s target rate of 2% for two years.

Ahead of the Bank’s Inflation Report next week, here is a quick overview of what’s kept inflation above-target:

Two years of temporary factors

1) VAT

The two increases in VAT, in January 2010 and January 2011, both had a year-long impact on the figure for CPI. This effect will fall out of the figures in January 2012.

VAT has a significant impact on consumer prices

12-month % change in CPI and CPIY (CPI excluding indirect taxes)

Source: ONS, 2011

2) Exchange rate depreciation

Though its impact was less marked this year than in 2010, the depreciation of sterling which started in mid-2007 added significantly to the cost of imported goods, thereby feeding through into consumer prices.

In the past year sterling exchange rates have been much more stable, and though high levels of uncertainty in Europe mean that this could change, there is no particular reason to think that sterling will drop significantly in value, as most commentators now believe the currency is closer to its true value.

3) Commodity price rises

As I have pointed out, pressure on producer prices has started to abate in the last few months. Weaker global demand would point to this trend continuing.

Although previous energy price-rises meant that energy providers have recently passed on big price rises to their customers, even this should work its way out of the inflation statistics by September next year.

Producer prices have stabilised in recent months

Producer Prices Index, Input Prices (2005=100)

Source: ONS, 2011

Tomorrow morning ONS will release the figure for CPI annual inflation in September. CPI inflation is widely expected to come in at over 5%, as energy price rises start to hit consumers.

As our forecasts show, this should be the peak for inflation, and recent comments from the Governor of the Bank of England suggest that inflation is now likely to fall below its 2.0% target in the medium term.

CPI inflation likely to edge over 5% in September, before falling back
Forecasts for annual % change in consumer price index  

In interviews following the bank’s latest interest rate decision, the Governor said he believed that the rate of inflation should fall back as temporary factors such of the VAT rise fall out of the measure, and weaknesses in the UK and global economy continue to weigh on demand.

There are still upside risks to inflation, though, particularly if increased inflation expectations begin to feed through to pay settlements, but the minutes from September’s MPC meeting suggest that this is less of a concern while the economy remains weak.

What to watch:

• There will be more information on the MPC’s latest thinking on Wednesday, when the minutes from the October meeting are released.
• We will also be releasing our Pay Settlements survey this week, which will give an indication as to whether industry is being affected by higher wage expectations (see last month’s press release).