Simon French, Chief Economist

Simon French is the Chief Economist at Panmure Gordon. Prior to joining Panmure he worked for the UK Government, latterly at the Cabinet Office as Chief of Staff to the UK Government COO.

He had a central role in implementing the Coalition Government’s spending reforms between 2010 and 2014 as well as working on the Governments Welfare and Pensions reforms between 2002 and 2008.

He holds an Undergraduate and Postgraduate degree in Economics from Durham University.

Background

This morning’s UK Inflation (CPI) came in at 2.9% – the highest level since May and above the BoE’s 2% target. Three questions:

  1. What are the prospects for the next 12 months?
  2. What is happening?
  3. What does this mean for the Bank of England?

What is happening?

The weakness in Sterling since last year’s referendum has pushed up import costs: Figure 1. This has been passed on to consumers initially in the form of transport costs (energy being predominantly priced in USD) and more recently in clothing and footwear: Figure 2 which was the big mover in today’s data.

What are the prospects for the next 12 months?

There are signs that inflation is near its peak. Figure 1 shows that the growth in import costs is already slowing and this should be translated into consumer prices in the coming months. Furthermore global commodity prices (including oil) have flat-lined over the last year – Figure 3. This was a big contributor to inflation in the early part of 2017 but its impact can be expected to weaken in Q4 – absent of a commodity price shock. Sterling has also stabilised – Figure 4 – which means that these combined pass-throughs from FX and commodities are past events not poised to repeat. Indeed looking at Gilts pricing (Figure 5) the market expects CPI to average less than 2% over the next 5 years.

F4

What does this mean for the Bank of England?

We are well known for being relaxed about the prospects of BoE rate hikes either on inflationary or macro-stabilisation grounds. There is nothing in the latest data to change that assessment.

What would shift the dial?

  • If we see the impact of inflation being a bid up in UK wages – the classic wage spiral of the 1970s where a commodity/ FX shock leads to workers demanding higher compensation. In this regard the possibility of a more generous public sector pay settlement for 2018 is material as an inflation-busting increase could generate sustained core wage inflation (Figure 6) of above 3% and trigger the requirement for higher rates. At present there is little evidence of the Treasury rolling over and playing dead on austerity – nor the private sector having to materially raise wages. BUT this is definitely an area to watch and can change quickly in the current political climate.

  • Alternatively you may see a shift away from inflation and growth concerns from BoE officials – and towards tackling financial stability risks. There are patches of this type of commentary BUT the BoE seem to prefer macroprudential interventions (e.g. Mortgage Market Review, PRA review of underwriting standards, Countercyclcial capital buffer, stress tests, leverage ratios) rather than interest rates to avoid these risks escalating. In the near term I think the BoE will be more concerned about patches of weakness in the UK economy (construction, consumer spending) and seeing how Brexit negotiations evolve, than making a move on UK rates.

Summary

UK inflation remains cyclically high but (like the rest of the developed world) structurally under pressure. This is in spite of headline tightness in labour markets that have historically led to wage inflation but whose transmission is currently blocked. The medium terms dynamics in FX and commodity prices should bring UK CPI back to target in H1 2018 – while concerns over the Brexit impact on the UK economy should lead to BoE officials favouring caution during the passage of Article 50.

We stick to our view that UK interest rates are going nowhere fast.