UK inflation: From too high, to too low?

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Annual inflation in the UK has dropped from 4 per cent to 3.2 per cent over the first quarter of 2024. Yet markets are now pricing in around two 25bps rate cuts this year compared to the six they had priced in at the start of January. Why?

Six cuts may have been ambitious to begin with. But the recent rise in rate expectations has been driven first by the possibility of “higher for longer” rates in the US and secondly by slightly higher than expected price growth prints (CPI in March came in a whole 0.1 percentage points higher than anticipated!). Both reasons are flawed, as one can probably sense.

Yes, a stronger dollar might eventually feed through to costlier UK imports. But the BoE would likely place more emphasis on the tightening in financial markets that comes with a stronger dollar, and transmits faster. Meanwhile, pricing rates warrants an assessment of where inflation is heading. Above-expectation data (for months already gone by) raises concern that underlying price pressures may be rebuilding, but the next step is to assess if that is true — rather than simply extrapolating it.

When annual CPI is broken down into its key components, its clear that it is mostly driven by services right now. Food and non-energy contributions have eased, and energy is actually pulling inflation down.

That’s the snapshot — it says nothing about where those contributions will be in the months ahead. So let’s look at each element in turn — starting with food.

How much consumers pay in the superstores reflect price pressures in the supply chain. Growth in producers prices for imported food materials and home produced food materials have fallen sharply over the past year. These changes percolate through the supply chain with a lag (six months or so seems to map on to consumer prices well). As such, end consumer food price growth should continue falling:

Now, energy. These price pressures also look tame. Gas prices help set the wholesale price of electricity. It again impacts consumer prices with a lag. Pushing it forward by around 12 months suggests the current trajectory of CPI energy inflation will remain low at least in the coming quarters (the energy price cap is also coming down):

Of course, food and energy are volatile components. They are vulnerable to shocks. But, in the base case, at least there does not seem much cause for concern. Even then, it’s better to focus on core inflation.

Starting with goods. Factory output price growth, pushed forward by a quarter matches up well with non-energy goods inflation. With supply chain pressures easing, and higher interest rates stretching manufacturers, it’s likely that price pressures in goods will continue to track producer price growth down:

Next, services. There is a fairly solid relationship between wages and services inflation. But what direction are they headed? The vacancy to employment ratio in services, a proxy for worker demand, is a decent indicator for future wage pressures. It is back to its pre-pandemic level, and suggests wages will continue to ease. Other indicators, including the BoE Decision Makers’ Panel Survey shows firms expect their wage growth to decline by 1.5 percentage points over the next 12 months:

Further cooling in the labour market, in part, depends on how tight economic conditions are in general. Annual growth in M4ex, a measure of broad money supply, has been particularly weak since last summer — partly reflecting the impact of higher rates.

There is a rough 18 month-ish lag between annual growth in M4ex and its impact on UK inflation (it takes time for credit and liquidity conditions to hit the real economy). It is not perfect, but if we take the relationship at face value, UK annual CPI could be hovering around zero in a year and a half. (Former BoE Chief Economist Andy Haldane said in February that he thinks the BoE risks deepening the UK’s recession if it does not start cuts soon.)

Summing across the leading indicators for food, energy and goods over the coming quarters suggest annual UK inflation could soon drop below the two per cent target, and may even be closer to zero at the start of next year.

How much lower inflation goes depends in part on one’s assumption of how persistent wage growth will be, and how much one thinks demand will drop below supply capacity. But, looking at current trends in wage growth, and what money supply growth suggests for forthcoming economic activity, it seems reasonable to think services inflation will come down somewhat too.

Paul Dales, chief UK economist at Capital Economics, concurs:

Our view is that average earnings growth slips to around 2 per cent, but then ‘settles’ around 3.5 per cent. The latter is consistent with CPI services inflation falling back to levels consistent with the 2 per cent inflation target.

As a result, Dales think that core inflation could hover around 2 per cent over the coming year (with a dip below target next year). And after factoring in the price dynamics in goods, food, and energy, he thinks CPI inflation could fall below 1 per cent later this year.

In summary:
— The market is overreacting to stickiness in America – and some higher than expected readings in the UK – and wrongly extrapolating from those developments
— Britain’s disinflation narrative remains alive and well. Services inflation needs to come down further, but its trajectory — and the economics underpinning it — look promising. Elsewhere, goods, energy and food inflation will pull headline inflation down. (Barring any further substantive shocks).
— Recent inflation prints should not change the BoE’s view too much. It expected CPI to average 3.6 per cent in Q1 — it came in closer to 3.5 per cent. (Markets are making more of a fuss about the 0.1 percentage point above expectation March print)
— The Bank needs to make more cuts – and probably sooner- than the market currently thinks. Any dithering may just elongate the need for ‘lower for longer’ later on.