Annual consumer price inflation fell unexpectedly to 0.9% in October and could undershoot the Bank of England’s 1.25% forecast for the fourth quarter. Sadly, this does not warrant any change to the view that inflation will rise sharply in 2017, probably exceeding 3% during the course of the year. Currency and commodity price effects are still a significant net drag on inflation currently but should deliver a major boost in early 2017. Strong monetary growth and a tight labour market, meanwhile, suggest that upward pressure on inflation will be sustained over the medium term.

“Core” CPI inflation – excluding energy, food, alcohol and tobacco – declined to 1.2% in October, a five-month low, with significant downward contributions from clothing (reversing a September boost), games and toys, student tuition fees and hotels. Changes in core inflation in recent years have been positively correlated with swings in the rate of change of manufactured import prices, lagged by a year – see first chart. The annual import price change reached a low of -5% in November 2015 but had rebounded to 5% by September 2016, with a double-digit gain likely by early 2017, based on the current level of sterling. This suggests a rising trend in core inflation from end-2016 through late 2017, at least.


Headline CPI inflation is still below the core rate currently because of negative and neutral contributions respectively from food and energy prices. With sterling commodity prices, however, currently 40% above their level at the start of 2016, the headline / core gap will soon turn positive and may reach 1-2 percentage points later in 2017 – second chart.


Faster headline price rises are more likely to feed back into higher wage demands now than when inflation spiked in 2008 and 2011, because the labour market is much tighter than then. The percentage of CBI industrial firms reporting a shortage of skilled labour rose to its highest since 1989 in October – third chart. EU free movement will no longer act as an automatic safety valve to prevent labour market overheating.


The monetary backdrop, in addition, is more inflationary. Annual growth of broad money, as measured by non-financial M4, fell sharply during the 2008 inflation spike and was below 2% in 2011; it rose to 6.8% in September 2016, an eight-year high – fourth chart. Broad money velocity fell by 1.1% per annum (pa) on average over the five years to mid-2016. If this rate of decline were to continue, sustained money growth of 6.8% pa  would imply nominal GDP expansion of more than 5.5% pa, in turn suggesting 3% plus inflation, assuming a potential output rise of no more than 2.5% pa.