CPI inflation was 0.5% in December 2014, well below the 2% target. The main reason for this was the steep fall in wholesale energy prices during the second half of last year. Inflation is likely to fall further in the near term, and could temporarily turn negative, as falls in energy prices continue to be passed through. Inflation is likely to rebound around the turn of the year as these effects drop out of the annual rate.
The fall in oil prices, together with monetary policy measures taken abroad, should support global demand. Lower energy prices will also boost UK real income growth. That, along with a lower expected path for Bank Rate than in November, should help to sustain the recent robust expansion in UK domestic demand. As slack is absorbed, inflation is projected to rise back to levels consistent with the inflation target. The Committee judges that it is currently appropriate to set policy so that it is likely that inflation will return to the 2% target within two years. Under the assumption that Bank Rate rises gradually over the forecast period, that is judged likely to be achieved.
Money and asset prices
Official interest rates in the United Kingdom remained at historically low levels. The European Central Bank announced details of an expanded asset purchase programme. And a number of other central banks cut their benchmark interest rates. Short and long-term interest rates fell across many advanced economies. In the United Kingdom, past falls in market rates have fed through into lower interest rates on household borrowing. Unsecured lending to households rose. Mortgage approvals for house purchase, however, were weaker than expected. Bank lending to businesses fell a little in Q4, although total net external finance raised increased.
GDP growth remained solid in 2014 Q3, and continued to be accounted for by rising private sector domestic demand. Household spending growth was robust. Business investment contracted in Q3, although survey indicators point to a recovery in Q4. UK-weighted world demand growth was subdued in Q3, and is expected to pick up only gradually. The trade deficit narrowed slightly, but the current account deficit widened in Q3, equalling its record high of 6% of GDP.
Output and supply
Output growth slowed slightly in 2014 Q4. Unemployment fell, broadly in line with expectations at the time of the previous Report, but both participation and employment growth were lower than expected. Average hours nevertheless continued to rise and indicators of labour demand remained strong. Overall, the margin of slack in the economy appears to have narrowed further. Four-quarter hourly productivity growth turned moderately positive in Q3.
Costs and prices
CPI inflation was 0.5% in December and is likely to fall further in the near term. To a large extent, the undershoot in inflation, relative to target, can be explained by lower energy, food and other goods prices. In particular, the sterling oil price has fallen by more than 50% since mid-2014. But it also reflects weak growth in domestic costs. Recently, earnings and unit labour cost growth have picked up. Indicators of inflation expectations have fallen. But, on balance, inflation expectations remain consistent with the MPC’s 2% target.
Prospects for inflation
CPI inflation has dropped sharply and is now well below the 2% target. That undershoot largely reflects unusually low contributions from oil, food and other goods prices. Those lower prices will bear down on annual inflation in coming quarters, but the path of inflation further out will depend on domestic pressures. Those domestic pressures have been weak, as seen in low wage growth in recent years. But domestic pressures are starting to pick up and are likely to build further over the forecast period, as a steady expansion in demand absorbs the remaining economic slack. The Committee judges that it is currently appropriate to set policy so that it is likely that inflation will return to the 2% target within two years. Under the assumption that Bank Rate rises gradually over the forecast period, that is judged likely to be achieved.