Despite Rising Inflation the Bank of England to Keep Policy Accommodative

The latest official inflation figures for the U.K. published on Tuesday showed that headline inflation year-on-year rose 1.2% from 0.9% previously, slightly higher than the 1.1% forecast. A less volatile measure that excludes food & energy known as core inflation increased over the past year to 1.4% from 1.2%, surpassing estimates for a reading of 1.3%.

At the same time, a measure of factory gate prices (referring to the prices of finished goods from manufacturers) known as the producer price index increased year-on-year 2.3% from 2.1% in October. A core measure of these prices also rose 2.2% from 2.0% previously over the same period.

Producer prices are a leading indicator for future inflation, given business needs to protect their profit margins they often pass on cost increases to the consumer. A measure of these costs producers are facing rose 12.9% year-on-year in November, up from 12.4% in October.

Predominantly the rise in prices can be attributed to two key factors, firstly the rebasing effect of earlier declines in the price of oil. On December 16th 2015 the price of Brent crude oil was US$37.19 compared to the price currently of US$54.23, a 45.8% increase. The second is the significant depreciation of the Pound following the Brexit referendum. While the Pound is well off the October 7th low of 1.1950 against the U.S. dollar and 1.0809 against the Euro, it is still down roughly 17% & 9.2% respectively since June 24th. This decline in the exchange rate increases the costs of imports which is seen through the rising PPI figures and also highlighted in a number of purchasing manager index (PMI) reports since July. 

GBP/USD (Blue) & EUR/GBP (Purple)

Source: Rivkin, RivkinTrader

Since July core consumer prices have risen from 0.6% year-on-year to the current 1.2% in November highlighted by the next chart. This has prompted speculation that in fact the Bank of England’s next interest rate change may be to increase borrowing costs rather than ease further. The BOE itself alluded to this following the August decision to leave interest rates unchanged at 0.25% and maintain asset purchases up to £445 billion. The statement notes that “monetary policy can respond, in either direction, to changes in the economic outlook as they unfold” when referring to the exchange rate and inflation.

Core Consumer Price Inflation

Source: TradingEconomics.com

Decisions around monetary policy do not simply rely on readings of inflation, they are complex, taking into account vast amounts of data that can often be ambiguous. Factors such an unemployment, wage growth, real wages (adjust for inflation), GDP, business sentiment, consumer expectations and a healthy functioning financial system all come into play. There are a lot of moving parts to this, so we’ll keep the focus predominantly on inflation.

The Bank has specifically referred to tolerating inflation above their target of 2% in the medium term. However these limits depend on the cause of the inflation, the effects on domestic costs, changes in inflation expectations and the shortfall in economic activity below potential.

Let’s examine what the bank is referring to when I mention the cause of inflation. There are different causes of inflation however we will focus on demand pull and cost push. Demand pull inflation occurs when aggregate demand increases faster than supply and typically occurs when the economy is growing at a rate higher than the longer-term trend. Demand exceeds supply and therefore prices rise.

The second type of inflation being cost push, where prices rise due to high costs of production associated with supply side factors. Examples include higher commodity prices (rising oil), imported inflation as a result of a depreciating exchange rate, higher wages and taxes. Cost push is often seen as less desirable given price rises are generally not accompanied by increased economic output. These supply side factors often prove temporary and a central bank is less likely to act on this type of inflation as a result.

The impact we are seeing on U.K. inflation is a result of cosh push inflation, as mentioned above referring to the rebasing of oil prices and the depreciating exchange rate. Therefore the Bank of England is likely to be tolerating higher inflation if it is caused by these factors, as long as they are likely to prove temporary. The caveat being that when faced with higher costs of living, workers demand pay rises which then feeds into longer-run inflation. Higher costs also feed into inflation expectations, which as a self-fulfilling prophecy can feed into actual inflation (if you believe prices will rise in the future you are more likely to spend today). So the causes and flow through effects of these increases in inflation need to be monitored closely.

In the November inflation report the bank forecasted inflation of 1.3% in 2016 before rising to 2.7% in 2017 & 2018 before settling back to 2.5% in 2019. At the moment inflation is tracking along these forecasts adding further weight to the view the bank should be comfortable with tolerating the current increase. 

There are a number of other reasons the Bank is likely to keep policy accommodative, we are witnessing a slowdown in the strength of gains in the labour market, productivity remains low relative to other developed countries, and while GDP has improved it is expected to decline in 2017 & 2018. Perhaps the most important factor is the pessimistic outlook given the expected impacts of the U.K. withdrawing from the EU.

A weaker Pound is beneficial for the U.K. economy, it provides a cushioning effect by increasing the competitiveness of exports (particularly services to the EU) while making imports more expensive which can result in increased demand for domestic goods as opposed to overseas. The issue becomes when we see sharp and volatile changes in the value of the currency, this causes uncertainty that weighs heavily on business and investors. The effect of the weaker Pound should prove temporary and suggestions of higher borrowing costs to offset this impact would result in lower output, lower wages and higher unemployment.

Overall the Bank of England is likely to keep stimulus measures unchanged in the coming months keeping the options available to them flexible. Inflation is currently being driven by factors that should prove temporary, although there certainly is the risk of these translating to have a more permanent impact. Looking ahead the risks are skewed to the downside despite the data so far suggesting the economy has held up relatively well following the Brexit however the hardest test lies ahead when negotiations begin. 

This article was written by James Woods - Global Investment Analyst, Rivkin Securities Pty Ltd. Enquiries can be made via james.woods@rivkin.com.au or by phoning +612 8302 3600.

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