Time for that letter Mr Carney

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CPI inflation fell to 0.5% in the 12 months to December triggering the Governor of the BoE Mark Carney to write a letter to the Chancellor explaining why inflation has dropped below the 1% benchmark. The drop is mostly down to the massive fall in the price of crude oil sparking deflationary pressures across the global economy.  

The 12-month inflation rate is the joint lowest on record; the last time the CPI increased by only 0.5% was in May 2000. The plummeting oil price has translated to a 10.5% drop in motor fuel prices which have also not been helped from an exceptionally warm winter. Food prices fell too by 1.9%, while restaurants and hotels are the only CPI component to have contributed positively to inflation compared to a year earlier.


Good or bad?

Analysts have anticipated this drop in inflation for some time now given the steady free-fall in the oil price as well as the slowdown in global growth. In fact, the certainty that inflation would fall below 1% was so high among commentators that the letter to the Chancellor is probably already written and tucked away somewhere in the Governor’s office. The debate has long refocused to whether very low inflation is good or bad for the economy?

The fact that the Governor is obliged to write a letter to the Chancellor explaining why inflation has hovered so far below the 2% target would suggest it’s bad. Economic theory tells us that low inflation can quickly turn to deflation (which is definitely bad) if consumers consistently postpone their spending in anticipation of even lower prices in the future. Inflation would turn to deflation and economic growth will stagnate as demand is sucked out of the economy.

Whether this actually materialises depends upon the characteristics of the economy in question as well as the causes of disinflation in the first place. A closer look into either parameter tells us that the probability of this happening is quite low.  


First, disinflation in the UK is mostly imported – through a plummeting oil price which is globally set and through deflation in the UK’s largest trading partner, the Eurozone, making imports cheaper. The fact that disinflation in the country is not a reflection of domestic economic conditions means that the consumer is less likely to respond by tightening his belt.

This takes us to the second point; the UK’s economic model has historically relied heavily on consumption and robust consumer confidence to drive growth. It was strong household consumption that kept the economy going during the recession and it would be hard to fathom that UK consumers will cut spending at a time where they see their real incomes rising.

So given that the likelihood for outright deflation in the UK is small, low inflation should be on aggregate a good thing for both consumers and businesses. Consumers see their real incomes rise and their spending power increase. Businesses see their input costs fall and production boosted. And investors can continue to invest at a negligible interest rate as low inflation continues to allow the BoE to keep the base rate at 0.5%.

But where there are winners there are usually losers. The oil & gas industry has been severely damaged by the plunge in the oil price. Another aspect is the country’s balance of payments; disinflation is causing the Pound to appreciate making exports less competitive and imports cheaper. Also, disinflation causes the value of debt to increase making debt repayments more expensive. So it is the risk of a worsening current account that should keep policymakers on their toes rather than fears about slowing growth.


Lower input prices for manufacturers

This disinflationary environment is good news for most manufacturers who see their input costs fall and pressure on their margins easing. Manufacturing – which is the most energy-intensive industry – is given a timely boost from lower energy prices. However, notable losers from the drop in the oil price are North Sea oil & gas producers as well as manufacturers who sell inputs (e.g equipment) into the industry.

Both output and input prices fell in the year to December – by 0.8% and 10.7% respectively. The massive difference between the two can potentially be explained by the fact that producers are trying to rebuild margins after facing a protracted period of squeezed profits. For output prices, the main cause of disinflation has been petroleum products whose price has fallen by 12.9% over the 12 months to December. The largest upward contributors have been tobacco & alcohol and clothing, textile & leather which have increased by 2.6% and 2.3% respectively.

For input prices, a staggering 35.7% decrease in the price of crude oil has been driving disinflation in producers’ input costs in the year to December. The price of home food materials also dropped considerably - by 12.3%. Core input price inflation however – which strips out the volatile fuel and food components – only fell by 1.9%. This is consistent with the view that the bulk of the disinflation momentum is caused by the fall in the price of imported crude oil. Indeed the price of imported materials (including crude oil) fell by a bulky 9.5%.


What does 2015 hold for inflation?

Given current global economic conditions it is highly unlikely that this will be the last letter that the Governor will need to write to explain why inflation fell below 1%. A slowdown in global growth in the middle of 2014 was already causing disniflationary pressures when the oil price shock hit the world economy. As the fall in the price of oil is a supply-side story we expect this to persist well in 2015 with inflation projections in the UK hovering below 1% throughout the year. Still, a lot will depend on how the ongoing battle for market share in the oil market will play out in the months to come.







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