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Monday January 23, 2006 - 11:46:47 GMT
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Economics Weekly: UK inflation risks still exist

Economics Weekly: UK inflation risks still exist
UK inflation is back on target
Latest figures show that UK consumer price inflation fell back to its 2% target in December, the first time it has been on target since June last year. This immediately triggered calls for a cut in interest rates, based on the poor performance of the manufacturing sector, rising unemployment, moderating wage inflation and below trend economic growth. But if there really is no inflation risk worth worrying about in the UK, why has the central bank not cut interest rates since a ¼% reduction in August 2005?

Low inflation, according to recent data…
Latest inflation data for the UK look benign. As chart a shows, all of the major measures of price inflation have fallen in the last few months. In December, headline retail price inflation fell to 2.2%, down from 2.4% in November. The old targeted measure - retail price inflation minus mortgage interest rates - rose by 2% in the year to December 2005, the same rate as the CPI and down from 2.3% in November. From a policy perspective though, they are sending different messages. With consumer prices on the 2% target, the implication is that monetary policy is actually spot on and interest rates should stay on hold, while the RPI measure of 2%, relative to the old 2.5% target, is suggesting that interest rate policy is too tight and that interest rates ought to be cut.

Core CPI (ex energy, food, alcohol and tobacco) inflation fell to 1.3% in February, the lowest annual rate since February 2005. The ‘high street’ continued help keep down inflation, with a drop in clothing and footwear prices of 4.2% in the year to December, though this was up from a 5.1% decline in November. This category actually boosted the annual CPI rate because it fell faster in December 2004 than in December 2005. In 2005 as a whole, CPI inflation averaged 2.1%, the highest annual rate since the series began in 1997 and up from just 1.3% in 2004. why has the MPC not cut interest rates?
The Monetary Policy Committee (MPC) set interest rates today to keep inflation on target over a two year horizon, so the current CPI rate should be a sign that 2 years ago policy was spot on (base rates in December 2003 were 3.75%). Looking ahead 2 years is therefore the focus of policy makers - not next month's inflation rate or even the next few months – as they cannot affect them near term, given the time it takes for changes in interest rates to impact inflation. But for those that think that the economy is weakening and therefore inflation will fall further – the current majority in the financial markets - the inflation data for December suggest that base rates could be cut, either in February or in May, by 0.25% to 4.25%. But this has not been the MPC’s view since August and these latest inflation figures may not change that; growth and inflation in the first half of 2006 are therefore key and it is still unclear at this stage whether growth will pick up or weaken further. But the low rate of inflation certainly seems to mean that should economic growth disappoint, then a rate cut or cuts is odds on.

Is the MPC worried about growth rebounding and higher oil prices?
In the last few months, transport prices have fallen and lower fuel and air travel have helped to depress the CPI. The average price of ultra-low sulphur petrol fell by 3p litre alone in December to 87.1p, the third successive month of decline. One of the problems for the MPC in the next few months, however, is that the recent rise in oil price to well above $60 a barrel will put upward pressure on just this element of consumer price inflation and could cause the overall index to rise back above 2%. Moreover, firms’ raw materials prices raced to an all time high of 17.1% in December, on higher oil prices, see chart b. This will act to push up energy costs, though output prices were only up by 2.4% in the year to December. Our estimates show a correlation of 0.76 (1 being a perfect fit) between firms’ input and output prices but a passthrough of only 1 tenth of 1 percent on average since 1990. That means the CPI impact just from this source is manageable, though concerning.

This suggests the MPC will wait to see how economic growth develops in the first half of 2006, keeping rates on hold next month. However, our forecasts suggest that economic growth will pick up in the second half of 2006 and not weaken as many expect. Retail sales growth is now recovering and the December rise of 12.6% in annual M4 money supply is a pace that the MPC will not ignore, especially as it is accompanied by a recovery in the housing market. The last thing the MPC would want to encourage is a return to boom conditions in the housing market after it has just successfully engineered a fall in prices without unduly damaging the economy.

Moreover, UK productivity growth (output per hour) has slowed and unit labour costs (wage growth minus productivity) are rising, putting more pressure on companies to raise their prices. Although much of this may be met by narrower profit margins, it is a factor the MPC is unlikely to take lightly, particularly if the economy is beginning to grow more quickly as consumer spending picks up offthe back of a recovering housing market. Just like the statistical relationship between firms’ raw material costs and their output prices, the pass through from higher unit labour costs to higher price inflation is slow to come through - there is a correlation but the interest rate implications may be more long term than short term.

There are still inflation risks and interest rates may remain on hold well into 2006
Taking all these factors together, and especially of unusually large price cuts in some retail items last year, our monthly forecast shows annual inflation may rise back above 2% in the first few months of 2006 before subsiding and remaining at or above 2% all year, see table 1. This analysis does not mean that interest rates will be raised any time soon, but does suggest that if economic growth recovers, then rate cuts seem difficult to justify. And if the economy recovers strongly, then there is a risk that the MPC may raise rates later in the year, albeit modestly.

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

Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.


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