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Economics Weekly - UK inflation to fall back sharply over the coming year; Weekly economic data preview - US recovery in the spotlight as Treasury sells a record $129bn of paper
Economics Weekly - 26 April 2010
UK inflation to fall back sharply over the coming year
Recent inflation developments have raised the spectre of a possible resurgence of sustained price pressures in the UK. Since dropping to a low of 1.1% last September, the annual rate of consumer price inflation has risen to 3.4% (see chart a). CPI inflation nhas now been above the governmentâs 2% target for four consecutive months, with the move above 3% in January prompting the BoE Governor to write an open letter of explanation to the Chancellor, explaining the reasons for the overshoot and the measures being taken to rectify it.
It has not only been CPI inflation that has risen noticeably. The rate of change of the broader retail prices index, which includes housing costs, has also rapidly reversed its previous decline. Since posting outright deflation of 1.6% in June 2009, annual RPI inflation has risen to 4.4%, as the fall in mortgage rates in late 2008 and early 2009 have dropped out of the annual comparison, and house prices have recovered.
Against the backdrop of rising commodity prices, a weak exchange rate, a recovery in economic activity and unprecedented policy stimulus, the rise in inflation has started to create some unease. There is particular concern that the pick-up in inflation could lead households and businesses to anticipate higher price increases in the future, setting in train a possible upward spiral of cost-push inflation.
Over the past year, survey and market based measures of medium- and long-term inflation expectations have remained relatively stable, although in recent months they have started to creep higher (see chart b). The sharpest increase has been in householdâs expectations of where inflation is likely to be in twelve monthsâ time. According to the our latest Lloyds TSB Consumer Barometer, this measure of inflation expectations has risen to 4.5% - a rise of 2.1 percentage points since last November (see chart b).
On the face of it, the rise in inflation expectations is concerning. Households inflation expectations, however, are heavily influenced by the prevailing inflation rate - the correlation between the annual CPI and householdsâ twelve-month inflation expectations is 0.85. For short-term inflation expectations, at least, the line of causation suggests inflation expectations should fall over the coming months if price pressures ease.
So what is the outlook for inflation? Although the risks have risen, our central view remains that inflation is likely to fall back sharply over the next twelve to eighteen months. The influences that have pushed inflation higher over the past six months appear to be mostly temporary, such as unfavourable base effects, the reversal of the 2.5 percentage point cut in VAT in January and the lagged response of the consumer price level to the rise in import prices. Unfavourable base effects have been particularly noticeable in fuel prices. Although fuel prices have risen sharply in recent months, the impact on the annual rate of inflation has been magnified by the fall in fuel prices this time last year.
Since inflation is a measure of the rate of change of prices, what matters for the inflation outlook is not whether the price level of goods and services rise over the next twelve months, but whether prices rise by more or less than they have over the past twelve months. While a further sharp fall in sterling, another rise in VAT and a renewed acceleration of fuel (and food) prices cannot be ruled out, the most likely outcome is that the impact of these influences will steadily dissipate over the coming year.
More generally, the underlying forces shaping the inflation outlook remain benign. As a result of the economic downturn, the UK is operating with significant spare capacity. This spare capacity is manifest in a substantial output gap, estimated to be around 5% of GDP. This spare capacity is most clearly evident in the labour market, with the level of ILO unemployment rising to a 14-year high of 2.5 million in February, or 8% of the labour force. The degree of spare capacity in product and labour markets has kept wage inflation below 2 per cent and has made it difficult for firms to raise prices.
Still, there is little doubt that firms are facing growing cost pressures. The fall in the exchange rate, coupled with the increase in commodity prices, has led to a substantial increase in input price inflation. Over the past year, producer input prices have increased by over 10%. As the latest increase in the CPI and the implied retail sales price deflator indicate, some firms have started to try and pass on these cost increases to protect their profits. This is particularly evident in goods prices, which are more sensitive to rising global raw materials costs than service sector prices. Having fallen sharply between 1999 and 2005, goods prices have risen by over 3% over the past year, overtaking the rate of inflation for consumer services (see chart c).
Looking ahead, the inflation outlook depends on whether these cost push inflation pressures intensify and, if so, how successful firms are at passing them on to consumers. While there is a non-negligible risk that import and commodity price inflation continues to intensify, input cost pressures are likely to be overshadowed by the reduction in unit wage costs over the medium term. It seems reasonable to expect the labour market will continue to lag the recovery in economic output, just as it lagged during the economic downturn. If so, productivity growth should rise. For a given level of wage growth, this should put downward pressure on unit wage costs. As chart d shows, unit labour costs have already started to decelerate in response to the cyclical recovery in productivity and we expect this trend to continue.
Overall, therefore, we remain of the view that inflation pressures will ease sharply over the medium term. By the end of 2010 and 2011, CPI and RPI inflation are forecast to have fallen to 2.0% and 2.7%, and to 1.2% and 2.2%, respectively. While the risks to inflation from the weakness of the exchange rate and rising global commodity prices should not be underestimated, the underlying inflation environment, remains, we believe, a benign one.
Adam Chester, Senior UK Macroeconomist, Corporate Markets
Weekly economic data preview 26 April 2010
US recovery in the spotlight as Treasury sells a record $129bn of paper
ô The FOMC interest rate decision on Wednesday provides the event highlight in financial markets this week. Although no change in the fed funds rate is expected, remaining at a record low 0-0.25%, the language used in the press statement will draw close scrutiny. The Fed completed its purchases of mortgage-backed securities and agency debt at the end of March and has closed the majority of its emergency liquidity programmes this year. After providing some key context round the term âextended periodâ in the March FOMC minutes - that it referred to the evolution of economic data rather than any fixed amount of calendar time - we do not expect to see the phrase removed until later this year. The economic outlook has improved, which we do expect the Fed to reiterate in the press statement, but not sufficiently, we believe, to warrant a hike in the benchmark interest rate until later this year. The other key uncertainty is whether the Fed will sell some of its portfolio of mortgage-backed securities and agency debt before hiking rates - we expect some mention of redressing the balance sheet in the statement. Mr Hoenig is expected to be the sole dissenter for the third straight meeting. We believe there is a strong chance the advance US Q1 GDP growth could exceed the consensus estimate of 3.3% on Friday. Consumer spending has been remarkably robust and the indications are that firms are restocking. We look for an annualised growth rate at 3.8%, down from 5.6% in Q4. Ahead of that, April consumer confidence on Tuesday may also surprise to the upside. In other events, the Treasury will auction a record $129bn in notes this week.
ô On Friday, Greeceâs Prime Minister George Papandreou announced that âit is a matter of national need to ask officiallyâ for the activation of the emergency financial stability package involving other euro-zone members and the IMF. This announcement represents a victory for financial markets, which had effectively backed Greece into a corner. The prospect of refinancing âŹ8.5bn worth of debt by mid-May at huge yield spreads over German bunds (close to 600bp on the 10-year) never looked realistic, with Moodyâs cutting Greeceâs credit rating only complicating matters further. With temporary respite on refinancing, Greece must now concentrate on sticking to its fiscal austerity programme â likely in an augmented form as a result of IMF involvement. Meanwhile, this week sees a busy euro-zone data calendar. Highlights include Aprilâs âflashâ CPI estimate â where we look for an outturn of 1.5% year-on-year â together with M3 money supply data and Marchâs unemployment rate. Weak money supply trends continue to feature in the euro area despite better signs from business surveys. Annual loan growth to the non-financial corporate sector, for example, remains deep in negative territory. This is likely to be the case until firms regain sufficient confidence on demand.
ô The UK sees a quiet week in terms of economic data releases, following last weekâs disappointment on Q1 GDP. The latter was a useful reminder that despite the continuing focus on an Asia-led global recovery, overall credit provision in economies like the UK remains weak, suggesting that a durable pick-up in domestic activity may still be some way off. In terms of upcoming UK releases, Aprilâs CBI Distributive Trades survey is released on Tuesday, where we look for a net balance of +10 retailers reporting higher sales volumes compared with a year earlier. We note that the annual comparison could be hampered by the timing of Easter last year. Latest Gfk consumer confidence data are also published this week, where we anticipate an outturn of -15, unchanged from March.
Jeavon Lolay, Senior Economist, Mark Miller, Global Macroeconomist
Economic Research,10 Gresham Street,
Lloyds TSB Corporate
London EC2V 7AE,
0207 626 - 1500
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