Are domestic inflationary pressures rising?

Published on 05 September 2019

Domestic inflationary pressures appear to be picking up, driven by increasing labour costs.

Domestically generated inflation (DGI) is the part of headline CPI inflation that reflects conditions in the UK economy. Headline inflation also reflects external factors such as changes in the exchange rate and world commodity prices.

DGI matters to the MPC because it provides useful information about the outlook for inflation. The influence of external factors on headline inflation will fade given enough time, so the level of DGI will determine where inflation settles.

There is a range of measures that help us judge whether DGI is rising or falling. At the moment, measures based on labour costs – the largest domestic cost facing most companies – look quite strong. Measures based on consumer services prices – which are generally provided domestically – look weaker, but have been picking up.

Chart A shows one labour cost-based measure. Unit labour costs (ULCs) are the cost of labour to produce one unit of output. The growth rate of ULCs has picked up lately as pay growth has strengthened, but growth in the amount of output produced per person has slowed.

Chart A

Unit labour cost growth has increased as pay has grown faster than productivity

Contributions to four-quarter private sector unit wage cost growth(a)

Chart A - Are domestic inflationary pressures rising?

Sources: ONS and Bank calculations.

(a) Private sector AWE regular pay divided by private sector productivity per head, based on the backcast for the final estimate of private sector output.

Chart B shows two price-based measures of DGI. The purple line in Chart B focuses on services that use a lot of labour – this ‘labour-intensive services CPI’ inflation rate has picked up significantly since 2015, although it has fallen slightly over the past two years.

Chart B

Indicators of DGI based on services prices have picked up since 2015

Indicators of domestically generated inflation

Chart B - Are domestic inflationary pressures rising?

Sources: ONS and Bank calculations.

(a) Labour-intensive services CPI contains the top 15 components of core services CPI by labour content, assessed using the United Kingdom Input-Output Analytical Tables 2014. Data are adjusted by Bank staff for changes in the rate of VAT, although there is uncertainty about the precise impact of those changes.

(b) The median annual inflation rate of around 190 services items in the CPI basket. These data have not been adjusted for changes in the rate of VAT.

An alternative method is to look at the median inflation rate of all the CPI’s services items. This measure has the advantage of being less affected by item-level volatility. The yellow line in Chart B shows ‘median services CPI’ inflation has picked up more gradually since 2015.

This post has been prepared with the help of Lee Robinson and Carleton Webb.

This analysis was presented to the MPC as part of its August 2019 round.

Share your thoughts with us at BankOverground@bankofengland.co.uk