CPI inflation is expected to have risen temporarily in July, in part due to higher energy prices. As well as energy, the rise in import prices following the referendum-related depreciation of sterling has held inflation above the 2% target. Most of that rise in import prices has now been passed on to consumer prices and so inflation is projected to fall back towards the target. Domestic inflationary pressures are building to more normal levels. Inflation expectations remain broadly consistent with the target.
4.1 Consumer price developments and the near-term outlook
CPI inflation was 2.4% in 2018 Q2, as expected in the May Report. Within that, the June inflation figure was 0.1 percentage points lower than anticipated (Chart 4.1), as upside news in energy prices was more than offset by downside news in a small number of non-energy goods components such as clothing and footwear, recreational goods and food prices. Much of that downside news appears to have reflected an unusual degree of discounting during the month, which is expected to be largely temporary.
Inflation is expected to rise temporarily to 2.6% in July, before falling back again from August (Chart 4.2). That occurs as the contribution from external costs — energy prices and the pass-through of higher import prices following sterling’s referendum-related depreciation — diminishes (Section 4.2). That decline is expected to be more gradual than projected in May, however, given the 2½% fall in sterling since the run-up to the May Report (Section 1).
In addition to external costs, the path for inflation will depend on domestic inflationary pressures. Those domestic pressures have been gradually picking up and are expected to remain firm (Section 4.3). In particular, labour cost pressures are strengthening (Section 3). Inflation expectations, which can influence wage and price-setting, remain consistent with inflation returning to the target in the medium term (Section 4.4).
CPI inflation is expected to have risen to 2.6% in July, and then to fall back from August
CPI inflation and Bank staff’s near-term projection(a)
- Sources: ONS and Bank calculations.
(a) The beige diamonds show Bank staff’s central projection for CPI inflation in April, May and June 2018 at the time of the May Inflation Report. The red diamonds show the current staff projection for July, August and September 2018. The bands on each side of the diamonds show the root mean squared error of the projections for CPI inflation one, two and three months ahead made since 2004.
Inflation is expected to fall during 2018 H2 as the contribution from fuels diminishes
Contributions to CPI inflation(a)
- Sources: Bloomberg Finance L.P., Department for Business, Energy and Industrial Strategy, ONS and Bank calculations.
(a) Contributions to annual CPI inflation. Figures in parentheses are CPI basket weights in 2018 and may not sum to 100 due to rounding.
(b) Difference between CPI inflation and the other contributions identified in the chart.
(c) Bank staff’s projection. Fuels and lubricants estimates use Department for Business, Energy
and Industrial Strategy petrol price data for July 2018 and are then based on the August 2018 Inflation Report sterling oil futures curve, shown in Chart 4.3.
4.2 External cost pressures
Global energy prices affect CPI inflation directly through their impact on petrol prices and domestic gas and electricity bills. Coupled with this, there are indirect effects, for example on production and transport costs, which take longer to feed through to consumer prices.
The sterling spot price of oil has risen by 7% since the May Report (Chart 4.3), primarily due to a depreciation of sterling against the US dollar. While there has been some volatility in recent months, the spot price has remained around 50% higher than in mid-2017. Changes in oil prices tend to be passed on to fuel prices, and therefore CPI inflation, relatively quickly. Accordingly, fuel prices are adding 0.4 percentage points to inflation at present (Chart 4.2). The oil futures curve — on which the MPC’s forecasts are conditioned — remains downward sloping, however. As such, the contribution from fuel prices to inflation falls over the next year, and turns slightly negative by mid-2019.
The gas futures curve has also risen, by around 15% since May (Chart 4.3), which will put upward pressure on retail gas and electricity prices. That follows rises in wholesale prices over the past year. The pass-through of wholesale gas prices to retail energy prices tends to take much longer than for changes in oil prices and the degree of pass-through varies over time. Rises in electricity and gas prices implemented by utility companies in recent months reflect earlier increases in wholesale prices being passed on with a lag.
Acting in the opposite direction, the announced cap on most standard variable tariffs (SVTs) — due to be implemented by the end of 2018 — may reduce some utility bills. There is currently uncertainty around the level of the cap, which will be determined by Ofgem, and therefore its precise implications for CPI. SVTs are the only tariffs currently captured in the CPI basket, so only changes in those tariffs will be directly reflected in CPI inflation.
Overall, the effects of higher wholesale gas costs on future household energy prices and of the tariff cap are expected broadly to offset each other. There is a large degree of uncertainty around the net impact and the timing, however, which could lead to some volatility in the contribution of energy to inflation over the next few years.
Non-energy import costs
In addition to higher energy prices, the period of above-target inflation since 2016 can be accounted for by rises in the cost of non-energy imports facing UK companies and households. Those higher import costs (Chart 4.4) largely reflect the referendum-related depreciation of sterling. In addition, world export price inflation — changes in the foreign currency prices companies in other countries charge for their exports — has risen during this period, in part due to a pickup in oil and other commodity prices (Section 1), which are inputs into the production of many goods and services.
Changes in the sterling value of foreign export prices tend to feed through to import prices within a year. As such it is likely that the effect of sterling’s depreciation around the EU referendum on import prices has already come through. Import prices are expected to have been broadly flat in the year to 2018 Q2 (Chart 4.4). Some pass-through from the recent depreciation in sterling, and the increase in foreign currency export prices (Section 1), are expected to push up import price inflation over the next few quarters (Table 4.A).
The rise in import prices since 2015 Q4 has in turn been passed on to consumer prices, although that pass-through has some way to run. That effect has been most apparent in the price of food and other goods (Chart 4.2 ), which tend to be more import-intensive. Non-energy goods inflation has slowed in recent months, and its contribution to CPI inflation is projected to fall slightly to 0.7 percentage points by the end of 2018 as the impact of sterling’s depreciation continues to diminish. That is consistent with responses to a recent survey by the Bank’s Agents on consumer demand. The effect of import prices on inflation is set to diminish further over the next couple of years (Section 5), albeit by slightly less than anticipated three months ago.
Sterling wholesale energy prices have risen further in recent months
Sterling oil and wholesale gas prices
- Sources: Bank of England, Bloomberg Finance L.P., Thomson Reuters Datastream and Bank calculations.
(a) Fifteen working day averages to 2 May and 25 July 2018 respectively.
(b) US dollar Brent forward prices for delivery in 10–25 days’ time converted into sterling.
(c) One-day forward price of UK natural gas.
Import price inflation has fallen back from previously elevated rates
Import prices and foreign export prices(a)
- Sources: Bank of England, CEIC, Eurostat, ONS, Thomson Reuters Datastream and Bank calculations.
(a) The diamonds show Bank staff’s projections for 2018 Q2.
(b) Domestic currency non-oil export prices as defined in footnote (d), divided by the sterling effective exchange rate index.
(c) UK goods and services import deflator excluding fuels and the impact of MTIC fraud.
(d) Domestic currency non-oil export prices of goods and services of 51 countries weighted according to their shares in UK imports. The sample excludes major oil exporters.
Monitoring the MPC’s key judgements
4.3 Domestically generated inflation
Inflation depends both on external cost pressures and on domestically generated inflation (DGI). DGI is influenced by the degree of spare capacity in the economy and, while it is not directly observable, there are a number of indicators that are closely linked to the concept. These include measures capturing labour costs — the largest domestic cost facing most companies — and the prices of services — which are generally provided domestically.
The degree to which wages and other labour costs affect inflation will depend on how fast they are rising relative to productivity — unit labour cost (ULC) growth (Section 3). Following the crisis, slack in the labour market weighed on wage growth and ULC growth was subdued (Chart 4.5). As slack diminished during 2016–17, ULC growth picked up. And in 2018 Q1 ULC growth picked up further, although it was boosted by temporarily weak productivity growth. Over coming years, the projected strengthening in wage growth is expected to push up domestic cost pressures relative to the past few years (Section 5).
In contrast to rising labour cost pressures, DGI as measured by services sector inflation has softened. One particular measure is inflation in the price of core services, which excludes components that are more likely to be related to tradable prices or government policy, such as airfares and education. That particular measure, which accounts for just over 40% of the CPI basket, fell to 2.0% in Q2, from an average of around 2½% during 2017 (Chart 4.5). That decline in part reflects previous erratic strength in a few components, such as coach fares and car insurance premiums, unwinding. In addition, services inflation is affected by external costs to some degree, as many service providers will use imported goods and services as inputs. Some of the recent fall in services inflation will therefore reflect the diminishing effect of the past depreciation of sterling.
Subdued services inflation also in part reflects low rent inflation, which fell to 0.4% in June from around 3% in early 2016, and is expected to remain subdued in coming quarters. Rent inflation is less directly affected by slack in the economy or external cost pressures, and is more closely related to developments specific to the housing market, such as the weakness in the London market (Section 2). Around half of the decline since early 2016 can be accounted for by lower rents paid for social housing — property owned by local authorities or housing associations. That has largely reflected the Government’s policy to reduce rents for most tenants in that sector by 1% a year from April 2016 until April 2020. Nonetheless, rents account for around 20% of the core services basket, so services inflation is expected to remain subdued and rise only gradually in coming months (Chart 4.2), despite the pickup in ULC growth.
Core services inflation has been subdued, but labour cost growth has picked up
Measures of domestically generated inflation(a)
- Sources: ONS and Bank calculations.
(a) Unit labour costs are whole-economy labour costs (including self-employment income) divided by real GDP, and unit wage costs are wages and salaries and self-employment income divided by real GDP; both based on the backcast of the final estimate of GDP. Core services CPI excludes airfares, package holidays, education and VAT; where Bank staff have adjusted for the rate of VAT there is uncertainty around the precise impact of those changes. All data are quarterly and up to 2018 Q1, except services PPI which are to 2018 Q2 and core services CPI which are quarterly averages of monthly data up to 2018 Q2.
4.4 Inflation expectations
Inflation expectations can influence domestic inflation through wage and price-setting behaviour. For example, if companies and households become less confident that inflation will return to the MPC’s 2% target, that may lead to changes in wage and price-setting that make inflation persist above the target for longer.
The MPC monitors a range of indicators derived from financial market prices and surveys of households and companies to assess whether inflation expectations remain consistent with the target. Shorter-term indicators of inflation expectations picked up during 2016–17 as CPI inflation rose, and as inflation has fallen back some of those indicators have fallen a little alongside it (Table 4.B). Some longer-term household indicators have edged up a little since 2016, although they remain close to past averages and so appear to be consistent with CPI inflation returning towards the target. Overall, the MPC judges that inflation expectations remain well anchored.
Indicators of inflation expectations(a)
- Sources: Bank of England, Barclays Capital, Bloomberg Finance L.P., CBI (all rights reserved), Citigroup, GfK, ONS, TNS, YouGov and Bank calculations.
(a) Data are not seasonally adjusted.
(b) Dates in parentheses indicate start date of the data series if after 2000.
(c) Financial markets data are averages to 25 July 2018. YouGov/Citigroup data are for July.
(d) The household surveys ask about expected changes in prices but do not reference a specific price index. The measures are based on the median estimated price change.
(e) In 2016 Q1, the survey provider changed from GfK to TNS.
(f) CBI data for the distributive trade sector. Companies are asked about the expected percentage price change over the coming 12 months in the markets in which they compete. The 2018 Q1 data point was pushed up significantly by one response.
(g) Instantaneous RPI inflation one and three years ahead and five-year RPI inflation five years ahead, implied from swaps.
(h) Bank’s survey of external forecasters. Inflation rate three years ahead.