Inflation figures released today confirm mounting deflationary pressures in the UK with the CPI index hitting a record low of 0.0% - the lowest CPI figure since records began in 1988. Deflationary pressures in the UK have been fuelled by a big slump in petrol and food prices.
Food prices have fallen by 3.4% and prices of motor fuels by 16.6% in the 12 months to February. These two product groups have reduced the CPI 12-month rate by around 0.9 percentage points. But other than a welcome boost to consumers’ coffers what does this mean for monetary policy?
‘Looking through’ inflation
The main drag on UK inflation has been the massive fall in global oil prices since June 2014. Together with falling prices in food, spurred on by the ‘supermarket price war’, these two forces are said to account for about three quarters of the fall in inflation.
The judgment on the origin of deflationary pressures is crucial for monetary policy vis-a-vis its impact on the Bank’s inflation projections; it determines to what extent the MPC can ‘look through’ inflation in its monetary policy decision.
Last month, Mark Carney put the fall in inflation down to ‘one-off temporary’ factors - something we explored further in our blog for January’s inflation data. The fall in inflation is not a reflection of domestic economic conditions and thus not a reflection of consumers' inflation expectations. What this tells us is that currently the Bank is comfortable enough to ‘look through’ inflation.
Indeed, the Governor has reiterated that while inflation might turn negative for a few months in 2015 the medium term expectation for inflation remains anchored at around 2%. There is thus no danger of persistent deflation and the Governor cited the lack of evidence for ‘deferred consumption’ – what essentially transforms disinflation into deflation.
But further cuts not ruled out
The Governor did say that the BoE is prepared to cut rates further if necessary, that is, if deflation proves to be sustained. However, this looks like an option of last resort for the Governor given his latest comments that cutting interest rates would be “extremely foolish”. Carney warned that the effect of the oil price will dissipate before a cut in interest rates kicks in adding “unnecessary volatility to inflation”.
The BoE’s Chief Economist Andy Haldane was less sanguine in his assessment of the Bank’s inflation profile. Haldane asserted that some of the deflationary pressures were rooted in the domestic market and concentrated chiefly on the labour market. Wages have been consistently trending below the BoE’s forecast suggesting that there is a risk that wages will not auto-correct in response to the fast absorption of slack in the labour market – which is the key judgement underpinning the Bank’s outlook for wages in the February inflation report.
Haldane identified some possible reasons for wages failing to ‘course-correct’. First, is that the Phillips Curve (i.e. economic theory of the inverse relationship between unemployment and inflation) has flattened over time and the impact of lower unemployment on wages has diminished. This could be because workers are now more willing to accept the existing wage, e.g. pension-age workers working longer or workers from overseas entering the UK labour force.
Another concern is the Bank’s estimation of slack in the economy. Weak wages could be explained by a larger output gap than currently projected which could be down to several reasons – such as greater spare capacity in firms. Finally, low inflation expectations could become entrenched either because of the above factors or in isolation. If this occurs it will affect companies’ wage-setting behaviour and households could defer consumption making the expectation of low inflation self-fulfilling.
He concludes that based on the current outlook there is no immediate need for a change in monetary policy. However, he sees that risks to the inflation forecast are ‘two-sided’ and in his personal view skewed on the downside. Given this uncertain inflation outlook the probability of a rate cut or rise is ‘evenly balanced’ for the BoE’s Chief Economist.
Tightening remains the most likely path
Despite the rate decision becoming more ‘evenly balanced’ for two of its members, the MPC unanimously voted to keep monetary policy unchanged. The Governor has emphasized that tightening remains the most likely path for monetary policy. Nevertheless, the inflation forecast remains uncertain and the BoE might have some difficult decisions to make if inflation moves into negative territory for the next couple of months.