Is the rise in inflation a sign of a strong economy? Will the Bank of England raise interest rates in response?
This week the latest UK inflation data was released: the annual change in the Consumer Price Index (CPI) rose to 1.8%, its highest since 2014, and is expected to rise further in the months to come, taking it above the Bank of England target rate of 2%. However, we do not expect the Bank of England to raise rates any time soon.
The rise in inflation is being driven by various factors:
- a recovery in the oil price from its lows in quarter one of 2016;
- the fall in sterling post the Brexit vote; and
- to a lesser extent, the rise in vegetable prices on the back of bad weather in southern Europe.
The currency move in particular has been slow to feed through to consumer prices as forward currency purchases have delayed the impact. Alternatively, it is possible that retailer’s profit margins have been squeezed where they have been reluctant to pass on price rises. The Producer Price Index (PPI) that measures input prices is more sensitive to these moves and was up 20.5% in the year to January 2017. This does not feed directly through to consumer prices and is a much more volatile index but we should expect further rises in CPI in the months to come.
However, these influences can be seen as short term, due to extraneous factors rather than demand driven. As such, they are unlikely to be repeated. The Bank of England looks further out and has tolerated inflation above target in the past. Their expectation is for inflation to be falling back in 2019 and as a result we should not expect an immediate response. If negotiations go well then we could see sterling move stronger again which would have a deflationary impact.
In the long run, there remain many deflationary influences in the world. These include internet price comparison, robots taking away jobs, globalisation of production and ageing populations in many developed countries. As a result, when we look through the short term noise we do not expect a return to the inflation of the late 20th century and, while rates will rise eventually, we believe the next peak in rates will be at a lower level than we previously experienced.
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