UK consumer price inflation fell to an annual 4.2% in December as energy and food prices slowed and the effects of last year’s VAT hike started to drop out of the comparison. A sharp decline in late 2011 had been widely predicted so today's news does not represent a favourable surprise. (A 4.2% end-year headline rate was forecast here in the summer.)
The December CPI print was above 2% for the sixth consecutive year.
The Bank of England’s claim that CPI inflation will fall dramatically during 2012, finishing the year below target, has, like its earlier optimistic forecasts, been accepted by the consensus – the average projection for the first quarter of 2013 is 1.9%, according to Consensus Economics. Such a plunge, however, requires a significant decline in “core” price momentum and / or further weakness in global commodity prices – both doubtful.
The first chart below shows one measure of core prices – the CPI excluding unprocessed food and energy incorporating an attempt to strip out recent VAT effects and adjusted for seasonal factors. The 12-month increase in this measure rose to 2.6% in December, the highest since January 2010. Six-month momentum of smoothed prices was slightly lower at 2.5%, having been stable during the second half of 2011, showing no response to economic weakness.
The six-month momentum measure has remained at or above 2% since January 2008. It failed to rachet lower in the wake of the “great recession” so is unlikely to drop suddenly now.
If core inflation remains resilient, forecasts of a sub-2% headline rate will depend on a big drag from food and energy prices. Food should have a favourable impact but energy and other industrial commodities tend to correlate with emerging-world economic activity, which is now reviving. The second chart shows the six-month change in the Journal of Commerce industrial commodity price index together with a leading indicator for the “E7” emerging economies. The leading indicator has recovered to a level historically consistent with rising raw material costs.
The third chart shows an inflation forecast based on stability in core price momentum and energy prices coupled with a fall in unprocessed food price inflation to 1% by mid-2012. It also incorporates a 0.2 percentage point upward impact from university tuition fees from October. Headline CPI inflation is projected to finish 2012 at 2.6% after reaching an interim low of 2.4% in August.
