For the pessimists in the forecasting community, this further reduces the chances of the MPC cutting interest rates significantly in the year ahead. We, however, think very differently. For a start, all of the acceleration between January and February was caused by gas and electricity prices rising by more than last year (adding 0.36 percentage points to the annual rate). But a key factor in this was a change in the methodology used to compile the index, with tariff increases now implemented at the time the change is made rather than phasing them in over a four month period as done previously to reflect the fact that the tariff didn’t affect customers until after their meter was read. True, alcohol and tobacco, clothing and footwear - and recreation and culture (mainly pre-recorded DVDs) each made small upward contributions to the annual rate, but combined they added no more than 0.07 percentage points. All other components had downward effects on inflation, the largest of which (perhaps surprisingly given all the recent media hype) coming from food and non-alcoholic beverages, mainly as a result of smaller rates of increase in fruit and vegetable prices compared with last year. Fuel and lubricants did rise on the month after having fallen 12 months ago, but this was more than offset by air and sea fares, which rose by less than a year ago.
Thus, it remains true that apart from one or two areas of the consumer prices index (most notably energy), which monetary policy can do very little directly to address, inflationary pressures remain subdued. Admittedly, these “one or two” areas are driving up the cost of living significantly. But by virtue of the fact that they are largely unavoidable at least in the short -term, they are more deflationary than inflationary as they reduce the amount of discretionary income available to spend on non-oil goods and services.
As such they only become relevant to the monetary policy debate if they are likely to feed through to inflation more generally. But to-date, such “second round” effects have been more notable by their absence. As the chart shows, whilst the headline rate has risen from 1.8% in August to 2.5% currently, the core rate – which excludes energy, food, alcohol and tobacco – has been moving in the opposite direction, falling from 2.0% back in June to 1.2% in February, the lowest since August 2006.
The problem for the members of the Monetary Policy Committee is that they are not sure how long this state of affairs will persist. In particular they are concerned that the huge divergence between the headline and core rates will be resolved by the latter rising to meet former, whereas we believe it is more likely to be the other way round. Crucial here is our judgement that the UK economy is operating beneath its productive potential. Not by much we grant you, but with growth now sub-trend and slowing sharply, the amount of spare capacity within the economy will increase quite quickly. This will maintain the downward pressure on core inflation, so that once the energy-induced spike up in the headline rate has passed, it will then follow the core rate lower. That said, in the short-term, headline inflation will rise further, moving as high as 3% or so by September. However, from there it will fall sharply, falling back to 2% by the year end and then to around 1.5% in early 2009. Whilst not as aggressive as the Federal Reserve has been in the last few months, we expect the MPC to bring official UK interest rates down to 4.25% by the end of 2008.
