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Economics Weekly - How big a risk is UK inflation? Weekly economic data preview - Will the first estimate of UK GDP surprise again in Q2?

Economics Weekly 19 July 2010


How big a risk is UK inflation?


The persistent overshoot of UK CPI inflation above the government’s 2 per cent target has started to raise concerns that price pressures are becoming entrenched. In 19 of the past 27 months, annual CPI inflation has exceeded the market consensus expectation, suggesting the models adopted by the economics community have failed to fully capture the current dynamics driving UK inflation or its measurement. In June, the annual CPI rose by 3.2%, the eighth consecutive month it has been above the 2 per cent target. Other key measures of UK inflation have been similarly strong.


The elevated level of UK inflation stands at odds with price trends elsewhere. In many other developed countries, inflation has either fallen or remained low as spare capacity in the product and labour markets has constrained the pricing power of both employers and employees (as traditional output gap models would suggest), see chart a.


To date, the relatively high inflation outturns in the UK have generally been dismissed as temporary, reflecting the coincidence of various one-off factors that could be expected to wash out of the inflation rate over time. Principal amongst these are the rise in VAT earlier this year, the unusually sharp rise in petrol and secondhand car prices over much of 2009, and the lagged impact of earlier sterling weakness on import prices.


Adjusting for these “temporary” factors, the inflation environment does indeed appear far more benign. Excluding the rise in indirect taxes, for example,= annual inflation (measured by CPIY) has declined from 3.1% to just 1.6% over the past year. Furthermore, the composition of UK inflation suggests the rise has been heavily influenced by the increase in transportation costs. Rising transportation costs alone contributed 1.4 percentage points (pp) to annual CPI inflation in June (see chart b). Over time, these “temporary” influences should fade.


Nevertheless, it is becoming increasingly difficult to argue that inflation is being driven by these “temporary” influences alone. Although headline inflation has dropped from a peak of 3.7% to 3.2% in recent months, “core” inflation (exc food and energy) has remained broadly unchanged at around 3%. It is clear that underlying inflation pressures have not eased as sharply as expected given the challenges facing the UK. The stickiness of inflation has been particularly noticeable in the services sector. While goods price inflation has fallen by over 1pp since January, services inflation has risen by broadly the same amount.


The resilience of core CPI inflation, coupled with the recent rise in UK inflation expectations, has begun to raise doubts on the MPC about how quickly inflation will fall back. The 2.5 pp rise in VAT next January only adds to the uncertainty.


Notwithstanding this, we expect underlying inflation pressures to moderate over the medium term. Although estimates differ, there is little doubt that the UK is operating with significant spare capacity. This spare capacity is clearly evident in the labour market. The level of employment has fallen by over 1mn since early 2008, nominal wage growth has stagnated, while real wages and unit labour costs are both now falling. Although economists may have fallen short of accurately forecasting inflation in recent years, with appropriate lags, there remains a reasonable correlation between inflation and the degree of economic slack. Chart c shows the relationship between the UK output gap and the change in RPIY inflation (retail prices excluding mortgage interest payments and indirect taxes). We have chosen RPIY instead of CPIY as it has a much longer history, but the two series are closely related.


The chart suggests that the output gap leads changes in annual RPIY by around four quarters. When the output gap is negative (i.e. the level of output is below potential) inflation tends to fall, and vice versa. The relationship suggests that inflation pressures are likely to moderate sharply over the coming years.


Nevertheless, as the shortcomings of UK inflation forecasts in recent years have highlighted, this output gap analysis does not provide a complete picture. The UK is a relatively open economy that is highly sensitive to external price shocks emanating from currency or commodity price movements. Our forecast assumes that neither movements in sterling nor commodity prices contribute significantly to changes in the inflation outlook over the coming years.


It also makes no allowance for possible structural changes in the transmission mechanism as a result of the credit crisis. Economic models are not particularly good at forecasting turning points. That challenge is made all the greater given the disruption to credit channels and the uncertainty surrounding estimates of trend growth. It is possible that, over the short run at least, the desire of firms to rebuild profit margins to repair their balance sheets may, when coupled with the increase in VAT in January, cause inflation to remain higher for longer.


Notwithstanding these risks and uncertainties, we retain our central forecast that UK inflation is likely to fall over the coming years. Our latest inflation projections are shown in chart d. Headline CPI inflation is forecast to drop to around 2.6% by the end of the year and to remain around this level through 2011, as the new VAT increase impacts, before dropping back below 2% from early 2012.


The annual RPI is also expected to slow sharply. Our RPI forecast builds on our CPI profile, but takes into account the expected profile for house prices and mortgage interest payments. Although we expect the inflation environment to weaken, mortgage interest payments are likely to rise modestly next year as the MPC seeks to reverse some of the insurance easing put in place during the credit crisis. While this should put upward pressure on the RPI, this is likely to be overshadowed by relatively weak house price growth and a general weakening of price pressures elsewhere. As such, we expect RPI to fall towards 2% over the medium term.


Adam Chester, Head of UK Macroeconomics


Weekly economic data preview 19 July 2010


Will the first estimate of UK GDP surprise again in Q2?


Marchel Alexandrovich, Mark Miller and Jeavon Lolay


􀂄 The UK calendar remains busy over the coming week with the release of retail sales, the first estimate of Q2 GDP and the Bank of England MPC Minutes set to hold the market’s attention. Although economic recovery in the UK appears to have gained some momentum over the course of the past several months, the household sector looks to have lagged behind. Growth in retail sales in particular has been mixed, with consumers remaining wary of spending on big-ticket items while also having their buying power squeezed by high inflation. In June, we expect a 0.5% monthly gain in retail sales volumes taking the year on year rate below 1% (sales volumes rose 1.7% last June). But due to the positive base effects related to Q1, for Q2 as a whole sales volumes will probably have increased by around 1.8% and implies a fairly sizeable contribution to

Q2 GDP growth. Combined with upbeat industrial production numbers it should mean that GDP in Q2 rose by around 0.6% - the strongest reading since 2007 (data out on Friday). Earlier in the week, on Wednesday, the Bank of England publishes the Minutes from its July MPC meeting. Last month saw the first member to dissent since September 2008, with Andrew Sentance voting for a 25bp rate increase. Given his recent comments, it is almost certain he would have done the same again in July. We think though that yet again he was probably alone in arguing for higher rates and expect to see another 7- 1 vote in favour of unchanged interest rates.


􀂄 Amid continuing uncertainty in financial markets, this week sees the long-awaited publication (on Friday) of the EU-wide bank stress tests. The tests will be conducted on a bank-by-bank basis with the objective of assessing the overall resilience of the EU banking sector. Specifically, they will examine banks’ ability to absorb further possible ‘shocks’ on credit and market risks (including sovereign risks) and to assess any dependence on public support measures. A ‘baseline’ and ‘adverse’ scenario will be used, with the latter assuming a 3 percentage point deviation in GDP relative to the European Commission’s forecasts over a 2-year time period. This scenario will also incorporate a ‘shock’ to interest rates to capture a rise in risk premia linked to a worsening of the euro-zone sovereign debt crisis. The tests have been welcomed by the ECB on the grounds of greater transparency. But for us, given that the tests include the German Landesbanken along with a good number of the Spanish cajas, the risks of igniting market fears about capital adequacy could still outweigh the perceived benefits of transparency. Beyond this, key euro-zone economic data this week include July’s German Ifo business climate index where we look for a pull-back to 101.3. Similarly, we anticipate a weaker pace of growth in July’s preliminary PMI surveys for the euro-zone, due on Thursday.


􀂄 In the US, the semi-annual Monetary Policy report will be presented by Fed Chairman Bernanke to the Senate on Wednesday, providing a detailed update on the economy and policy outlook. Last week’s inflation data underlined that price pressures remain subdued, raising renewed concerns about the lingering risk of deflation. It is a relatively quiet week for US economic releases, with the focus on the housing market. We look for housing starts and building permits to show a further fall in June as the expiration of government initiatives weighs on the market. Existing home sales could show a particularly sharp fall.


􀂄 In other events, the Bank of Canada is forecast to raise interest rates for the second successive month to 0.75% on Tuesday. The Brazilian central bank on Wednesday is likely to lift the selic rate by 0.75% for the third straight meeting to contain inflation.



Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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