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UK inflation: Easter effect obscures strong upswing

Posted on Tuesday, April 11, 2017 at 02:37PM by Registered CommenterSimon Ward | CommentsPost a Comment

UK annual consumer price (CPI) inflation was stable at 2.3% in March but remains on course to move above 3% in the second half of 2017, implying a significant overshoot of the Monetary Policy Committee’s central forecast (showing inflation of 2.6% and 2.7% in the third and fourth quarters respectively).

CPI inflation was suppressed by a 23% year-on-year fall in air fares due the later timing of the Easter holiday this year compared with 2016. This effect subtracted 0.2 percentage points from the headline rate but will reverse in April.

The forecast of a move above 3% is based on “core” inflation – defined here as the annual CPI increase excluding energy, food, alcohol, tobacco and education, and adjusted for VAT changes – rising to about 2.5% by late 2017 and the headline / core gap climbing to more than 1 percentage point. The air fares effect resulted in the core rate retreating from 1.9% in February to 1.7% in March – see first chart. Seasonally-adjusted core prices, however, rose at a 2.5% annualised rate in latest three months from the prior three, consistent with the forecast – second chart.

The headline / core gap, meanwhile, increased to 0.6 percentage points in March, the highest since 2013, and the lagged relationship with sterling commodity prices suggests that it will peak well above 1 percentage point later in 2017 and remain elevated into 2018, unless commodity prices weaken or the exchange rate rallies significantly – third chart.

A post last month argued that inflation is rising in lagged response to a significant increase in monetary expansion between 2011 and late 2016. The fall in the exchange rate has been part of the “transmission mechanism” from loose money to faster price rises, rather than being a primary driver. The historical evidence is that money growth peaks lead core inflation peaks by between two and three years. Assuming that annual broad money growth topped out last autumn*, the suggestion is that inflation will remain under upward pressure through late 2018, at least.

*Annual growth of non-financial M4 peaked at 6.8% in September 2016, falling to 5.4% in February 2017 – see previous post.

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