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Monday October 17, 2005 - 10:01:17 GMT
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Should there be more concern about UK consumer price inflation?

Economics Weekly: Economic Research and Analysis -

Should there be more concern about UK consumer price inflation?

Inflation to remain in the news
With the release of September consumer price data this week, and the minutes of the Monetary Policy Committee (MPC) that month (when interest rates were left on hold at 4.5%), UK inflation is once again a key focus of interest. Financial markets are expecting there to be a cut to 4¼% in UK base rates at the November MPC meeting. This clearly suggests that they are not overly concerned about the rise in headline consumer price inflation, attributing it to oil induced price increases that are likely to prove temporary, especially since annual economic growth was just 1.5% in the second quarter of 2005. But our detailed analysis of the latest consumer price inflation data suggests that it is more of a risk going forward than financial markets are expecting, and the headline data suggest. And so the UK central bank may not cut interest rates, and the recent turn upward in bond yields may be heralding a return to worrying about inflation in fixed income markets.

Oil prices have pushed up price inflation..
As chart A shows, there has been a sharp rise in fuel and energy related prices, which have had the effect of dragging up overall consumer price inflation. Detailed figures from the Office for National Statistics (ONS) show that electricity, gas and other fuels were 12.2% higher in August than in the same period of 2004. Of course, there is also likely to be indirect effects on other sectors, such as transport and road haulage and on services that are highly dependent on oil. But accounting for these, suggests only a little over half of the rise in the CPI since last year has been due to higher energy prices. (Our calculation shows that energy has been responsible for 0.67 of a percentage point of the increase in the annual increase in the
consumer price index from 1.1% in September last year to the current rate of 2.4%. But this means that the other 0.63% is due to pressure of demand on resources within the UK.)

…but account for only half of the increase...
Chart B shows that services prices within the consumer prices index are rising much quicker than those of the total index, reflecting the faster pace of output growth in the services sector of the economy (around 0.8% a quarter or 2.8% at an annual rate). This is seen both in a rise in services relative share of the economy and in its rise as a share of the consumer prices index - where the weights for the categories are based on the amount that households spend on them each year. prices are rising...
Service price inflation was up by 4.5% in the year to August, nearly twice as fast as that of the total consumer price index in the same period. But within this increase, prices rose by an even more rapid 6.3% for housing and household services; 5.4% for transport services; 5% for education services; 3.6% for restaurants and hotels and 5.1% for services not included in these categories.

...and import are prices now pushing up goods prices
But rising UK import prices are also signaling that the period of sharply falling goods prices may be coming to an end, partly a result of sterling weakening. This is not to suggest that the world or UK economy are on the verge of an inflation episode, but simply that it will be harder to set UK interest rates in a less deflationary world that had helped to keep down the domestic inflation rate in the past.

Chart C illustrates this point by showing that UK import prices, excluding oil, are rising, coinciding with a less deflationary price environment for goods prices. This means that UK goods prices have been kept down by falling import prices, not domestic events, as this comes to an end, then there will be upward pressure on domestic prices. This is even if imported goods from China and India remain very cheap. But setting UK interest rates for domestic conditions will be harder in the next few years than in the recent past. Financial markets are currently reacting mainly to weakening UK economic growth and ignoring headline inflation, but our analysis suggests that the central bank will need to be cautious in setting interest rates because the inflation background it operates in has worsened. This means ‘core' consumer price inflation, i.e., ex energy and food, which has also been rising, may accelerate further, perhaps to above the 2% inflation target, setting a barrier to lower interest rates. It would appear odd for the UK monetary authorities to be the only major central bank not to be concerned about inflation risks.

UK economic indicators
Attention this week will be on the consumer price inflation data, on Tuesday. A further rise above the 2% target, which is expected to taken it to the highest level since March 1996, will make it difficult for the MPC to lower interest rates, even with weak economic growth. Data on Friday are expected to show that quarter on quarter growth in Q3 may be a little weaker than in Q2 but the annual rate may have picked up. The minutes of the October MPC meeting, on Wednesday, will give a guide to how the committee members are interpreting the recent economic data and the direction of risks. There could have been at least one vote for a rate cut.

Trevor Williams, Chief Economist
[email protected]
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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