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Economics Weekly - UK price inflation: ‘sticky’ but set to fall further; Weekly economic data preview - Data to show eak UK consumer spending

Economics Weekly - 24 August 2009

 

UK price inflation: ‘sticky’ but set to fall further

 

 

UK consumer price inflation stubbornly high...

In July, UK price inflation was well above financial market expectations, recording a 1.8% annual print, significantly higher than the consensus estimate of 1.5%. The ‘core’ rate, which excludes food, energy,

tobacco & alcohol, rose to 1.8% from 1.6% in June, while both key measures of retail price inflation were also higher at -1.4% (RPI) and 1.2% (RPIX). Although the latest data contrast with the view from the Bank of England that inflation will slow in the near-term (largely due to base effects such as past hikes in utility prices falling out of the annual comparison), the Inflation Report also noted that the monthly profile was likely to be unusually volatile in H2 2009. Month-on-month rates for CPI, core CPI, RPI and RPIX were all unchanged in July compared to June, against expectations of falls of around 0.3%.

 

...but the trend is downward...

But the big picture trend is that UK price inflation is falling, and was below the Bank of England’s 2% target for a second consecutive month at 1.8% in July, see chart a. Retail price inflation is falling more sharply than consumer price inflation (CPI) because it is more affected by the two and a half percentage point cut in VAT and lower interest rates, but it is the CPI that we will focus on, as it is the key measure used to compare price inflation trends between countries. Looking internationally, the fall in UK price inflation is slower than in other comparable countries, see chart b. The chart shows that US CPI inflation was -2.1% in July, and that eurozone inflation was -0.7%. In Japan, there was deflation of -1.8%, a record low in a decade of falling prices.

 

But should the inflation outcome for the UK not be viewed as a success for the Monetary Policy Committee (MPC), as the strategy around quantitative easing (QE) is to avoid inflation falling too far below the 2% target? The answer partly lies in whether CPI inflation stays at current levels or falls significantly further in the period ahead – following the path already taken by the other economies shown in chart b. Hence the question: is UK CPI inflation ‘sticky’, i.e., resistant to falling because of some fundamental or structural problem with prices in the UK or will it drop significantly further in the next few months? The official position is clear on this point: ‘It is more likely than not that inflation will temporarily fall below 1% in the autumn...’. The central forecast also shown in the Bank of England’s August Quarterly Inflation Report is that CPI inflation, even on the basis of Bank rate remaining at 0.5% and £175bn of quantitative easing (QE), ends up below the 2% target in two years time.

 

...and official forecasts show CPI inflation below 2% in 2 years time... This means that as far as the MPC is concerned there is no barrier to CPI inflation falling further in the UK. The minutes of the August MPC even suggested that the MPC was prepared to write an open letter to the Chancellor explaining why inflation had fallen by more than 1% below the 2% target - just as they had to write letters last year explaining why it had risen by 1% above the target. So why, so far, has UK CPI price inflation not fallen as much as it has in the US, eurozone or Japan, as highlighted in chart b? Wage inflation, one of the major influences on price inflation, does not appear to be a reason why UK CPI inflation is higher than in other major developed economies. Chart c shows that UK wage inflation has fallen back as much as the average of other countries. Another major component of CPI inflation is import prices. Chart d shows just how well correlated UK price inflation is with import prices: falling import price pressure means falling CPI inflation pressure.

 

As import prices have a big role to play in generating CPI inflation, comparing the UK with other major developed countries might be useful in drawing out the differences in CPI inflation between them. Chart e which shows that UK import price falls are not as sharp as in the other countries. This partly explains why UK CPI inflation has not fallen as much as in these other economies. One of the key reasons why UK import price inflation has not fallen as much is due to the rapid depreciation of the pound. Some 13% of the near 30% decline over the last year has been reversed since March, see chart f. If maintained, this implies that UK import price inflation could fall back further. But another reason for believing that UK CPI inflation can fall further is the large negative output gap, the extent to which actual output is below potential output.

 

...though likely to take a volatile path, CPI inflation will be driven lower by a large negative output gap

The near-term path of CPI is likely to remain volatile, but our forecast shows that it will fall below 1% in September, prompting an open letter to the Chancellor from the Governor of the central banks, see chart a. UK CPI inflation will remain below 1% for some months, and then gradually rise back as economic recovery resumes and the effects of a rise in VAT impact in year on year comparisons. But the large amount of spare capacity in the economy will bear down on inflation in the medium term, even accepting that some of the lost capacity may be scrapped and never brought back into actual production. Based on the economic profile and the implied output gap, a long period of low UK inflation lies ahead. Hence, it is entirely possible that despite a return to positive UK economic growth in Q3, the Bank of England may still embark on more quantitative easing in November.

Trevor Williams, Chief Economist, Corporate Markets


Weekly economic data preview - 24 August 2009

 

Data to show weak UK consumer spending

The first expenditure breakdown of UK Q2 GDP is likely to confirm that consumer spending and capital spending contracted once again. Although retail sales picked up in the second quarter, total consumer spending will be considerably weaker. The CBI distributive trades survey will provide an early snapshot of retail activity in August. In the eurozone, the German IFO survey is expected to rise for fifth consecutive month, but given the degree of spare capacity in the economy, inflationary pressures are expected to remain weak, with Germany providing an early indication of August CPI inflation. In the US, the Treasury will sell $109bn of government debt securities. The second estimate of US Q2 GDP may be revised lower, but expectations are for a return to growth in the current quarter. Consumer confidence on the Conference Board measure may rise for the first time in three months.

 

􀂄 UK retail sales volumes have improved in recent months, rising 1.2% on a quarterly basis in the three months to July. However, as chart 1 shows, growth in overall consumer spending has been somewhat weaker than retail sales recently, driven by weaker spending on services. We expect this trend to have continued in Q2, with total consumer spending down about 1% on the quarter. Gross fixed capital formation is also expected to have contracted, weighed by uncertainty regarding economic and housing market prospects, as well as constrained credit availability. We have not pencilled in a revision to overall Q2 GDP, but the risk may be skewed towards a slight upward revision. Looking ahead, we see a fall in the CBI distributive trades survey in August, but consumer confidence may register a marginal improvement. The bottom line is that the strength and sustainability of any recovery is far from certain.

 

􀂄 The eurozone composite PMI survey rose to 50.0 in August in last week’s release, the strongest level since May 2008. The increase was helped by an unexpected surge in German services PMI to 54.1, well in excess of the 50 ‘no change’ level, while French manufacturing PMI also moved into growth territory at 50.2. The German IFO survey this week is expected to show a fifth consecutive monthly rise from 87.3 to around 88.5 in August. This survey, however, has shown a less buoyant rebound in economic activity than the PMI survey (see chart 2), suggesting that a strong economic recovery is by no means assured, especially as money supply figures could show further weakness in loans growth to households and companies. Inflationary pressures are likely to remain weak, with German annual CPI expected to remain negative.

 

􀂄 In the US, markets will be digesting the $109bn of supply from the Treasury, comprising $42bn of 2yr, $39bn of 5yr and $28bn of 7yr notes. Data wise, there could be a downward revision to Q2 GDP, but the focus is on whether the recession is near an end. Fed Chairman Bernanke last week said that the global economy is starting to emerge from recession. Durable goods orders are forecast to rebound in July, helped by the cash-for-clunkers programme and stronger aircraft orders. However, any recovery is likely to be gradual. Underlying this expectation, consumer confidence has surprised on the downside recently, though the Conference Board measure this week may show the first rise in three months.

Hann-Ju Ho, Senior Sector Economist

-

 

Economic Research,
Lloyds TSB Corporate
Markets,
10 Gresham Street,
London EC2V 7AE
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www.lloydstsb.com/corporatemarkets

 

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12:30 US- Housing Starts & Permits
14:30 US- EIA Crude
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01:30 AU- Employment
08:30 GB- Retail Sales
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Fri 20 Oct
12:30 CA- Retail Sales & CPI
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  • POTENTIAL PRICE RISK: HIGH Tue-- 08:30 GMT GB- CPI top tier confirmation of Inflation.

  • POTENTIAL PRICE RISK: Medium Tue-- 09:00 GMT DE- ZEW Survey second most important German monthly Survey.

  • POTENTIAL PRICE RISK: Medium Tue-- 09:00 GMT EZ- final HICP revision to flash report. Revisions are usually minor.

  • POTENTIAL PRICE RISK: Medium Tue-- 13:15 GMT US- Industrial Production. Top output indicator.



  • POTENTIAL PRICE RISK: Medium Wed-- 12:30 GMT US- Housing Starts and Permits revision to flash report. Useful housing leading indicator.

  • POTENTIAL PRICE RISK: Medium Wed-- 14:30 GMT US- EIA Crude. Top WTI inventory measure.



  • POTENTIAL PRICE RISK: Medium Thu-- 01:30 GMT AU- Employment. Top economic indicator.


  • POTENTIAL PRICE RISK: Medium Thu-- 02:00 GMT CN- GDP. Top economic indicator.


  • POTENTIAL PRICE RISK: HIGH Thu-- 08:30 GMT GB- Retail Sales. Top consumption indicator.


  • POTENTIAL PRICE RISK: Medium Thu-- 12:30 GMT US- Weekly Jobless. Employment Indicator.



John M. Bland, MBA
co-founding Partner, Global-View.com

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