Posts here in 2013 suggested that the trend in UK core and headline consumer price inflation would change from down to up in early 2014 in lagged response to faster monetary growth and labour market tightening. The core rate did pick up into mid-2014 but then reversed course sharply, falling to a new low in the first half of 2015. Headline inflation bottomed at -0.1%. What went wrong?
The forecast was invalidated by two major developments: the effective exchange rate surged by 15% between 2013 (calendar year average) and August 2015, putting strong downward pressure on manufactured import prices; and plunges in crude oil and natural gas prices from June and November 2014 respectively cut household energy bills and reduced costs for suppliers of core goods and services.
A case, nonetheless, can be made that domestically-generated inflation has followed the expected path. The annual rate of change of unit labour costs, in particular, rose from -2.0% in the second quarter of 2014 to 2.0% in the third quarter of 2015 – see first chart. It may have remained at around this level in the fourth quarter, with recent slower pay growth offset by weaker productivity performance.
The disinflationary impact of the strengthening exchange rate, meanwhile, has probably peaked. The average level of the effective rate in January is still slightly higher than in January 2015 but it has fallen by 5% since August.
Core consumer price inflation, therefore, has started to recover. The annual change in the CPI excluding energy, food, alcohol and tobacco rose from a low of 0.8% in June 2015 to 1.4% in December. A narrower core measure also excluding education (to avoid a distortion from the large rise in undergraduate tuition fees from 2012) has increased more sharply, from 0.5% to 1.3% – second chart.
The argument that core inflation would rise was based on historical lagged relationships with monetary growth and measures of labour market slack. The labour market has tightened significantly further since the first half of 2014. The unemployment rate has fallen from 6.5% then to 5.1% in the three months to November, with the November single-month estimate at 4.9%. The stock of unfilled vacancies has risen by 18% since the first half of 2014, while the recruitment difficulties index in the December Bank of England’s agents’ survey reached its highest level in data extending back to 2005.
Broad money trends have also strengthened. The preferred broad measure here under normal circumstances is non-financial M4, comprising money holdings of households and private non-financial corporations. Annual growth of this measure, however, is currently understated because of households switching funds from bank deposits into the Osborne election bonds made available to pensioners by National Savings for a brief period in early 2015 – such bonds would be included in M4 if issued by a bank instead of the government. A wider aggregate including all National Savings products grew by an annual 6.6% in November, the fastest since May 2008 – third chart.
Strengthening credit growth suggests continued solid broad money expansion. The M4Lex lending measure (i.e. bank lending to the private sector excluding “intermediate other financial corporations”) rose by an annual 3.5% in November, the fastest since April 2009. The stock of arranged but undrawn sterling credit facilities, meanwhile, has surged, a development that normally signals stronger lending expansion – fourth chart.
The tentative view here, therefore, is that the recent increase in core inflation, unlike the 2014 firming, will be sustained (with due allowance for monthly volatility). Domestic arguments for a rise are stronger now than in early 2014, while the exchange rate drag is likely to lessen, with possible downward pressure on sterling from Brexit uncertainty.
If correct, Bank of England Governor Mark Carney was unwise to validate expectations of a further extended interest rate hold in a speech this week. This signal threatens to accelerate the pick-up in credit growth and sustain broad money expansion at a level likely to be too high to be consistent with 2% inflation over the medium term.