Inflation nears 2% Bank of England target

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Inflationary pressures continued to rack up in the first month of 2017, with CPI increasing to 1.8% from 1.6% in December 2016.  This rate is as close to the Bank of England’s (BoE) 2% inflation target as it’s been for over two and half years, or more precisely since June 2014.


Is it the lower sterling effect?

While the impact of the pound depreciation on CPI inflation has started to emerge, the bulk of the increase in inflation is accounted by the increase in fuel prices. That is, fuel prices contributed to around half of the 1.8% increase in the inflation rate in January. This mostly reflects movements in the price of crude oil, which has increased by 88.2% since January last year. Of course, the sterling devaluation has also played its part by pushing up sterling oil prices.  


Swelling input costs for manufacturers

The impact of sterling’s depreciation can be seen more starkly in the swelling cost base of manufacturing businesses, with producer price inflation hitting highs not seen for several years. Input prices for manufacturers increased by a staggering 20.5% in January, the fastest rate of annual growth since September 2008.

The increase in the price of crude oil and the pound depreciation – down about 13% on the year – were once more the main culprits, with imported materials and fuels contributing 17.3pp to the 20.5% increase in input costs.   


Passing on the costs

Manufacturers are looking to pass on their ballooning input costs to customers, with output prices increasing for a seventh consecutive month to 3.5%. These 7 months of increasing prices follow a prolonged two year period of deflationary pressures.


Nevertheless, with input prices increasing at an almost six fold pace compared to output prices, the gap between what it costs manufacturers to produce one unit of output compared to what they can charge for it is ever widening. This is inevitably putting the squeeze on manufacturers’ profit margins and any relief is unlikely in the near-term as base effects from fuel prices and the depreciation of the sterling are likely to continue to push up inflation over the course of 2017.

Rising input prices appear to be the fly in the ointment for manufacturers at a time when output is surging, macroeconomic conditions are looking more supportive and the UK's new industrial strategy approach is being sketched out.


Bottom line?

The bottom line is that stuff is getting more expensive, creating a monetary policy dilemma for the BoE. Higher inflation could spell lower GDP growth, as consumers adjust their spending to lower real incomes. But controlling inflation through higher interest rates could stifle investment, generate unemployment and increase borrowing costs for both consumers and businesses.

In its February Inflation Report, the BoE showed its willingness to tolerate a temporary period of above target inflation to support growth through loose monetary policy. However, it also signalled that its tolerance for protracted high inflation is limited. Whether that tolerance is tested will largely depend on the strength of consumer spending and the trajectory of pay growth.




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