By Lucy O’Carroll
Annual UK inflation has registered its first zero reading in 55 years. According to the Office for National Statistics, February’s unchanged headline number was driven by declines across a range of prices -including transport, food, furniture and computer equipment– offsetting modest price increases elsewhere.
What are we to make of this? First, it is part of a global phenomenon. Worldwide CPI inflation currently stands at 1.2%, having fallen by 1.8 percentage points (pps) in the past two years. Around 40 countries are currently experiencing deflation. In response, central banks have cut interest rates and introduced unconventional policy measures, including quantitative easing. At present, two-thirds of countries globally have policy interest rates below 3%. UK rates have been at an historic low of 0.5% for the past six years. And despite the fact that global economic activity appears to be accelerating – we are projecting global GDP growth of 3.4% this year and 3.9% next, up from 3.3% in 2014 – the easing trend has continued. On latest reckoning, more than 25 central banks internationally have loosened monetary policy so far this year.
Bank of England (BoE) Governor Mark Carney has, however, argued that it would be “extremely foolish” for the UK to join them. In his view, the current low-to-negative inflation environment is a temporary, and broadly positive, one for the UK economy. This is because it is mainly the result of ‘external’ factors, such as lower oil and agricultural commodity prices, which do not signal any fundamental economic weakness. Indeed, by effectively putting money back into the pockets of households and firms, who will now be spending less on such necessities, they should encourage potentially more productive forms of spending and investment, boost growth and underpin higher rates of inflation in the medium term. So if the BoE were to join the other 25 central banks and add to monetary stimulus, it could simply increase the chances of overshooting its 2% inflation target two or three years from now.
The BoE’s Monetary Policy Committee (MPC) is not of one mind, however. MPC member Andy Haldane may not be worried about the two-thirds of record low inflation that can be explained away as temporary, but he is definitely concerned about the remaining third that may be more stubborn. This brings us to one of the most striking puzzles of the UK economic recovery. Employment has risen by over 600,000 in the past year, to an all-time record rate of 73.3%, but pay growth has remained very subdued. On the latest reading, regular pay (excluding one-off bonuses) rose at an annual rate of only 1.6% in the three months to January – well within the 1-2% range it has broadly maintained over the past five years. Mr Haldane’s worry is that falling UK inflation expectations, driven partly by sterling’s strength squeezing import prices, may be influencing wage- and price-setting in a way that entrenches weak inflationary pressures more permanently into the UK economy. As a result, wages and prices may now be less responsive to increasing activity and employment, and declining spare capacity, than in the past.
Given that price cuts from British Gas, the UK’s largest utility company, will show up in the inflation numbers for the first time next month, consumer price inflation (CPI) could turn negative in the March data, for the first time ever. In our view, and that of the majority on the MPC, inflation is likely to remain below or close to zero for much of the rest of the year. However, we expect it to pick up as the temporary effects of falling oil prices diminish, the economy continues to expand at a healthy pace, spare capacity is absorbed and wages and prices respond relatively ‘normally’. On this basis, CPI inflation is projected to rise from just 0.2% this year to 1.8% in 2016, and the Bank of England is likely to start raising interest rates early next year.
Mr Haldane is right to point out the risks, however. After all, six years ago, when UK interest rates were cut to 0.5%, financial markets were anticipating a first rate rise by the end of that year. The financial crisis, and the policy tools that have been employed in response, have certainly altered ‘normal’ economic relationships. The issue is whether these alterations are temporary or something more fundamental. Mr Haldane’s analysis suggests the latter; on his argument, any further delay in the long-anticipated pick-up in wage inflation would provide supporting evidence, and any further rise in sterling would only add to the risks. Thus developments in two markets – for labour and for sterling – are crucial to the projected path of UK inflation and interest rates over the next 12 months.
Lucy O’Carroll is chief economist at Aberdeen Asset Management
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