UK annual consumer price inflation fell from 1.0% in November to 0.5% in December (0.55% before rounding). The decline was entirely due to a faster rate of decline of energy prices – down an annual 5.8% in December versus 0.2% in November*. “Core” inflation – excluding energy, food, alcohol and tobacco – recovered to 1.3% last month from 1.2% in November.
This core measure understates domestic inflationary pressure because it incorporates a drag on prices of tradeable goods and services (excluding energy and food) from sterling strength in 2013 and the first half of 2014. Non-energy industrial goods prices fell by an annual 0.3% in December; without sterling’s appreciation, they might have risen by about 1%**. This suggests a negative impact on core inflation of about 0.5 percentage points***.
Sterling’s effective rate has stabilised since mid-2014 and manufactured import prices have started to recover, rising an annual 1.0% in November versus a 4% fall in March. This may be reflected in firmer consumer prices of non-energy industrial goods in early 2015.
Bank of England research confirms a large drag effect from the exchange rate on current inflation. In a speech in October, MPC member Kristin Forbes reported simulations on the Bank’s COMPASS model suggesting that 2013/14 sterling strength would cut CPI inflation by about 1 percentage point by end-2014, up from about 0.4 percentage points in the first quarter
An alternative approach to gauging domestic inflationary pressure is to focus on services inflation, which is less affected by changes in commodity prices and the exchange rate, although not impervious****. Annual services inflation was 2.3% in December versus 2.4% a year earlier.
The official consumer prices index (CPI) excludes owner-occupiers’ housing costs. The alternative CPIH measure includes such costs using a “rental equivalence” approach, but the Office for National Statistics has stated that its estimates of rental inflation are biased downwards. It recently started to publish an alternative series for owner-occupiers’ costs based on the “net acquisitions” approach; this rose by an annual 4.1% in the third quarter – see previous post for more details. An alternative measure of services inflation incorporating this series using the relevant CPIH weight stood at 3.0% in the third quarter.
The suggestion that domestically-generated inflation is above 2% is supported by recent national accounts prices data, with the caveat that these are subject to revision. The deflator for “gross value added at basic prices” – a measure of prices of domestically-produced goods and services sold both in the UK and overseas – rose by an annual 2.4% in the third quarter.
*The energy weight is 8.0%, implying an impact of -0.45 percentage points.
**Annual inflation averaged 1.0% over 2010-14.
***Based on a 39.7% weight of non-energy industrial goods in the core basket.
***Examples of effects include foods costs on catering services, energy costs on transport services and the exchange rate on foreign holidays.
The global longer leading indicator* tracked here continued to firm in November, suggesting that a recent recovery in industrial output growth will be sustained through spring 2015.
The indicator is giving a more hopeful message than a year ago. The first chart shows the position at end-2013. Global growth – as measured by the six-month change in output in 14 large economies – had reached its highest level since October 2011, contributing to widespread optimism about 2014 prospects. The leading indicator, however, had fallen significantly from a peak in July 2013, suggesting an economic slowdown during the first half of 2014.
The second chart shows the current position. Global growth moved lower from January 2014, bottoming in August before recovering through November. The leading indicator, meanwhile, revived in early 2014 and has continued to rise recently.
Economic uncertainty has been heightened by a 44% plunge in the oil price, as measured by spot Brent, between June and December 2014. Some commentators argue that this weakness is a negative signal for the global economy. The table documents changes in global growth six and 12 months after previous large oil price declines. The six-month results are mixed but growth was higher in all five cases after 12 months.
|OIL PRICE DECLINES OF 30%+ OVER SIX MONTHS|
|CHANGE IN SIX-MONTH INDUSTRIAL OUTPUT CHANGE*|
|AFTER SIX MONTHS||AFTER 12 MONTHS|
|*G7 + E7 FROM 1998, G7 BEFORE|
A lower oil price transfers income from exporters to importers. Assuming that importers’ marginal propensity to consume / invest is higher, this transfer should boost growth. In the short run, however, exporters may cut spending more quickly than importers raise it, resulting in a neutral or negative impact. The table suggests that positive effects dominate after 12 months.
*The indicator combines a large number of forward-looking data series and leads cycle turning points by about six months. The November reading incorporates December data where available in the calculation of trends in the components.
The annual change in Eurozone consumer prices dropped to -0.2% in December from 0.3% in November, with the negative reading reflecting falls in energy and unprocessed food prices. Excluding these categories, prices rose by an annual 0.7%, unchanged from November. A narrower “core” inflation measure excluding energy, food, alcohol and tobacco firmed to 0.8%, above its level at end-2013 – see first chart.
Core inflation is unacceptably weak but the ECB has already reacted, cutting official rates in June and September, offering cheap long-term funding for bank lending and embarking on QE focused on private-sector securities. Monetary policy affects the economy with a six to 12 month lag and inflation after about two years. Monetary trends provide early evidence about its effectiveness. Six-month growth in Eurozone narrow money M1 rose from 4.1% annualised in May, before the ECB’s first rate cut, to 9.9% in November. Broad money M3 growth increased from 1.0% to 5.3% over the same period. The euro’s effective exchange rate, meanwhile, has fallen by 4% since mid-2014.
The economic definition of “deflation” is a pervasive and persistent decline in prices associated with sustained money and credit weakness. The Eurozone isn’t in deflation currently and the risk of it entering such a scenario has diminished.
German releases today were encouraging, with the level of unemployment falling to a 23-year low in December, unfilled vacancies at a new record and retail sales volume rising by a solid 1.0% in November (although monthly changes are notoriously volatile). The German economy is effectively at full employment: the unemployment rate stood at 5.0% in November versus 5.8% in the US and 6.0% in the UK in the three months to October – second chart.
A major weakness of the official consumer prices index (CPI) is its omission of owner occupiers’ housing costs. The Office for National Statistics (ONS) publishes a companion measure, CPIH, incorporating such costs using the “rental equivalence” method, which imputes rents on owned homes based on those paid on similar properties in the rented sector. The European Commission, however, has decided to base future changes in its harmonised CPI system on the alternative “net acquisitions” method, which measures the costs of purchasing and maintaining a home. The ONS recently started publishing an owner occupiers' costs series using this method. As explained below, an inflation measure incorporating this series would have provided better signals for policy-makers than CPI or CPIH in recent years.
The first chart shows quarterly data for annual CPI and CPIH inflation since 2006. The latter has been consistently slightly lower because imputed rents are estimated by the ONS to have risen more slowly than the CPI*. The difference has averaged only 0.2 percentage points, however, so monetary policy would probably have been the same if the MPC had focused on CPIH instead of CPI inflation.
The second chart compares CPIH inflation with an alternative housing-inclusive measure incorporating the new ONS owner occupiers’ costs series based on the net acquisitions approach**. The latter series gives a significant weight – currently 26% – to house prices. The alternative measure was higher than CPI / CPIH inflation in 2006-07, lower in late 2008 and 2009, and higher again in 2010 and early 2011. A focus on this measure, in other words, would have encouraged tighter policy in 2006-07, when monetary / credit conditions were excessively loose, while suggesting greater room for easing in late 2008 as the recession was gathering pace – the MPC delayed the launch of QE until March 2009.
The alternative measure would have made a stronger case for withdrawing some policy stimulus in 2010, a change that would have tempered the 2011 inflation spike. The MPC, however, might have chosen to ignore the signal because of concern about the growth impact of the pre-announced January 2011 VAT rise and worsening Eurozone economic conditions.
The alternative measure is giving a less dovish message than CPI / CPIH inflation currently, standing at 1.8% in the third quarter of 2014 (the latest available figure) versus 1.4% in both cases. Indeed, “core” inflation (i.e. excluding energy, food, alcohol and tobacco) on the alternative basis was 2.1% in the third quarter – third chart. Reflecting recent house price strength, owner occupiers’ costs rose by an annual 4.1% in the third quarter using the net acquisitions approach versus only 1.0% on a rental equivalence basis.
*The ONS plans to implement methodological “improvements” that will raise its historical and current estimates of rental inflation. The “National Statistics” status of CPIH was temporarily withdrawn in August 2013 pending these changes.
**The alternative measure was calculated by substituting the net acquisitions series for the rental equivalence series in CPIH while maintaining the same basket weight (currently 16%).
Eurozone monetary trends are sending an increasingly positive message for economic prospects. The narrow M1 and broad M3 aggregates posted further chunky monthly gains of 1.2% and 0.7% respectively in November. Six-month growth of real M1 and M3 (i.e. deflated by seasonally-adjusted consumer prices) rose to 4.7% and 2.5% (not annualised), the fastest since 2010 and 2009 – see first chart. This pick-up reflects faster nominal monetary expansion not falling prices – the CPI edged up by 0.1% in the six months to November.
The six-month real M1 change is an excellent leading indicator of the economy: it turned negative ahead of the 2008-09 and 2011-12 recessions, resuming growth before the intervening and subsequent recoveries. The current strong pace of expansion suggests upside risk to the consensus forecast of Eurozone GDP growth of 1.1% in 2015. Real M1 is now rising more rapidly than in the UK in early 2013, ahead of major positive growth surprise.
M1 has probably been boosted by interest rate declines and an associated rise in spending intentions, reflected in an increased transactions demand for money. M3 is more supply-driven: growth continues to be supported by a large balance of payments surplus*, while bank lending to government has picked up (partly in response to the TLTROs), outflows from longer-term savings instruments into deposits have increased and private sector credit contraction has slowed – adjusted for sales and securitisation, bank loans to non-government residents rose marginally in the latest three months.
The ECB publishes a country breakdown of overnight deposits, comprising about 80% of Eurozone M1. The pick-up in Eurozone six-month real deposit growth has been driven by the periphery (i.e. Italy, Spain, Greece, Ireland and Portugal) – second chart. Of the big four economies, growth remains strongest in Spain but is now significantly higher in France and Italy than Germany – third chart.
*Basic balance, i.e. current account plus net direct / portfolio investment flows.