CPI inflation has remained around 3%. The overshoot of the 2% target is almost entirely due to the effects of higher import prices, following the depreciation of sterling. As these effects begin to diminish, inflation is expected to fall, but the recent rise in oil prices means that fall is more gradual in the near term than projected in November. Alongside that, wage growth appears to be picking up, suggesting building domestic cost pressures.
CPI inflation rose to 3.1% in November, triggering an open letter from the Governor to the Chancellor of the Exchequer, before falling back to 3.0% in December (Chart 4.1). That was higher than the 2.7% projected in the November Report, reflecting the impact of higher global oil prices on retail fuel prices (Section 4.2) and larger-than-expected contributions from recreational goods and airfares, although these components tend to be volatile.
Continued above-target inflation over the past year has predominantly reflected the rise in import prices following the depreciation of sterling since November 2015 (Section 1). Higher import prices are being passed on to retail prices, pushing up inflation for those components that tend to have the greatest imported content, for example food, energy and other goods (Chart 4.2). Those contributions are probably close to their peak, and inflation is expected to fall back towards the 2% target gradually as the effects of the depreciation begin to diminish.
The further rise in global oil prices since the November Report adds to external cost pressures, however, at least over the next year or so. As such, the fall in CPI inflation is projected to be more gradual in the near term than expected at the time of the November Report. And it is possible that CPI inflation could rise back above 3% temporarily.
The path for inflation further ahead will depend on the balance between the speed at which the effects of higher import and energy prices diminish (Section 4.2) and the pace at which domestic inflationary pressures rise. Measures of those domestic pressures have been subdued but there are signs of a modest strengthening (Section 4.3). In particular, unit labour cost growth is projected to be supported by a rise in pay growth in response to the tightening in labour market conditions (Section 3).
In the run-up to the February Report, the sterling spot Brent oil price was 15% higher than at the time of the November Report and was at its highest level since late 2014 (Chart 4.3). That reflected a sharp rise in US dollar oil prices following the strengthening in global economic activity and only moderate growth in oil supply (Section 1).
Changes in oil prices tend to be passed on to fuel prices relatively quickly. The further rise in oil prices since November is expected to push up CPI inflation in 2018 Q1 by an additional 0.2 percentage points, although that is partly offset by the impact of the freeze in fuel duty announced in the November 2017 Budget.
Although the spot price of oil is higher, the oil futures curve, on which the MPC’s forecasts are conditioned, has risen by less and continues to slope downwards. That downward slope pulls down projected inflation during 2019 by just under 0.1 percentage points on average, a slightly bigger drag than implied at the time of the November Report.
Rises in retail gas and electricity prices in the first half of 2017 have been pushing up inflation, but those rises will drop out of the annual comparison in coming months. Partly offsetting that, some small increases in utility bills are expected towards the end of 2018, as more recent rises in sterling spot wholesale gas prices, and the sterling gas futures curve on which the MPC’s projections are conditioned, feed through.
As set out in previous Reports, recent above-target inflation has reflected higher non-energy import prices facing UK companies. That largely reflects the depreciation of sterling, which is 16% below its November 2015 peak. In addition, world non-oil export prices — the foreign currency prices companies in other countries charge for their exports — weighted according to countries’ shares in UK imports, have risen in recent years (Section 1) and are projected to increase slightly further during 2018.
Between 2015 Q4 and 2017 Q3, non-energy import prices rose by 10% (Chart 4.4), just under half of the rise in sterling world export prices. As explained in the box on pages 28–29 of the November 2015 Report, Bank staff have estimated that, on average, 60% of changes in the sterling value of non-energy world export prices are subsequently reflected in UK import prices. As most of that occurs within a year the current degree of pass-through is a little less than expected and, in addition, some indicators of import price inflation have fallen (Chart 4.4). Depending on how companies react to the change in the exchange rate, it can take longer for the full effect to come through. As such, import prices are expected to rise a little further in 2018. There is a risk, however, that the shortfall in import prices relative to the size of the fall in sterling is not fully made up.
The rise in non-energy import prices since the end of 2015 has accounted for most of the rise in companies’ costs over that period. That appears to have squeezed consumer sector companies’ profit margins (Chart 4.5), although these are being restored as companies pass cost increases on to higher retail prices. As explained in the box in the November 2015 Report, the CPI is estimated to rise by around 30% of any rise in import prices. This pass-through has been gradual, on average, in the past with the peak impact on inflation after a year and inflation continuing to be pushed up for a further three years after that.
In the November 2016 Report, the MPC judged that the pass-through from higher non-energy import prices to consumer prices was likely to occur more rapidly than in the past, due to the nature of the depreciation. It is difficult to measure the precise degree of pass-through but, if anything, it appears to be a little greater than expected so far. Inflation among more import-intensive components of the CPI — those components that are imported or have an above-average share of imported inputs, and are therefore most affected by import price increases — has risen sharply (Chart 4.6).
Overall, the impact of the depreciation of sterling on CPI inflation is broadly as expected and is probably close to its peak. That contribution is likely to fall back over the forecast period but the precise path will depend on the speed and extent of further rises in import prices (Section 5).
Once the transitory effects from the fall in sterling have passed through, and in the absence of further external cost shocks, CPI inflation will be mainly determined by domestic inflationary pressures.
The cost of labour, and in particular wages, is the largest domestic cost facing most companies and hence is a significant driver of domestic inflationary pressures. The degree to which those costs affect inflation will depend on growth in unit labour costs (ULCs) — the labour costs associated with producing a unit of output.
ULC growth has slowed since the end of 2016 (Chart 4.7). That mainly reflects a decline in the contribution from non-wage labour costs, which had previously been pushing up ULC growth as a result of higher pension contributions. Forthcoming increases in minimum contributions for auto-enrolled pensions will continue to push up non-wage labour costs but, as these rises affect only a subset of employees, the impact on aggregate ULC growth is expected to be modest.
Pay growth has also been weighing on ULC growth in recent years. During the financial crisis, pay growth slowed as unemployment rose. But even though unemployment has fallen back in recent years, to its lowest level since 1975, pay growth has remained subdued relative to historical norms.
For the most part, the weakness of pay growth reflects slow productivity growth (Section 3), so has not affected ULC growth (Chart 4.7). One factor that is likely to have been weighing on both productivity and wage growth in recent years is changes in the composition of the workforce. During a downturn in the economy, job losses tend to be concentrated in lower-skilled, lower-paid roles. Fewer lower-paid workers mechanically lifts average pay even if the wages of those remaining in work are unchanged. As the economy recovers and unemployment falls, this effect tends to unwind, depressing measures of average wages as those out of work find jobs. This effect is estimated from LFS data to have reduced annual pay growth by around ½ percentage point in 2017 Q3 (Chart 4.8). But, to the extent that has also been associated with lower productivity (Section 3), ULC growth will have been less affected.
Weak pay growth over the past is also likely to have reflected slack in the labour market, which will have weighed on ULC growth. The extent to which lower unemployment puts upward pressure on wages and inflation depends on where it is relative to the equilibrium rate, which in turn depends on the structural features of the labour market. As discussed in Box 4, the limited response of wage growth to falling unemployment is one of the reasons why the MPC judges that the long-term equilibrium unemployment rate is probably around 4¼%, lower than assumed in previous Reports and broadly in line with the current headline rate of unemployment, at 4.3% in the three months to November. The drag from unemployment on wage growth is therefore likely to dissipate in coming quarters.
Consistent with pay pressures starting to build as slack has been absorbed, data from the Annual Survey of Hours and Earnings suggest that pay growth for those switching jobs, rather than remaining in the same job, has returned to around its pre-crisis rate (Chart 4.9). Reports from the Bank’s Agents suggest that firms have targeted pay rises to those employees likely to switch jobs in recent years. The REC indicator also shows some rises in pay growth for new recruits (Table 4.A).
There are also signs that pay growth is starting to rise more broadly. Three-month regular pay growth relative to the previous three months has remained around 3% on an annualised basis (Chart 4.10), somewhat higher than expected in November. In addition, annual wage growth will be boosted over coming months as the weakness of pay in late 2016 and early 2017 drops out of the annual comparison.
Results from the Bank’s Agents’ annual pay survey are consistent with an increase in pay growth. The survey recorded an average pay settlement in the private sector of 2.6% in 2017, higher than companies had expected in the survey a year ago. In 2018, the average private sector pay settlement was expected to be ½ percentage point higher, at 3.1%. With the exception of construction, average pay settlements were predicted to rise in all sectors in 2018. Respondents to the survey had reported that the main factors pushing up total labour cost growth per employee were the ability to recruit and retain staff, employer pension contributions, higher consumer price inflation and the National Living Wage.
Overall, regular pay growth is projected to rise in coming quarters, at a slightly faster pace than expected at the time of the November Report (Table 4.B). In addition, slightly stronger-than-expected bonus payments are boosting total annual pay growth, which is expected to reach around 3% in 2018 Q1. ULC growth is expected to have risen in 2017 Q4 (Chart 4.7), by more than anticipated in November, and to remain firmer as pay growth continues to outstrip productivity growth (Section 5).
ULC growth is one indicator of domestically generated inflation (DGI), but there are a number of other measures that are closely linked to that concept. As discussed in the box on page 28 of the May 2017 Report, these measures, while useful, can also be misleading at times, especially following large changes in sterling’s exchange rate.
While most measures of DGI point to a slowing in recent quarters, that mainly reflects the effects of sterling. Measures of service sector inflation and those based on the GDP deflator rose following the depreciation of sterling from November 2015 and have fallen back in recent months (Chart 4.11). Abstracting from these effects, DGI is probably just a little below past averages.
Inflation expectations can influence 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.
Indicators of households’ short-term and long-term inflation expectations have risen in recent quarters (Table 4.C). Those measures can be sensitive to the current level of inflation and are likely in part to reflect the recent pickup in CPI. Most household measures remain broadly around past average rates, however. And professional forecasters’ expectations and those derived from financial markets have been broadly stable.Overall, the MPC judges that inflation expectations remain well anchored, and that indicators of medium-term inflation expectations continue to be consistent with a return of inflation to the 2% target.
CPI inflation has remained around 3%
CPI inflation and Bank staff’s near-term projection (a)
Inflation is expected to fall a little in Q1
Contributions to CPI inflation (a)
Oil prices have continued to rise
Sterling oil and wholesale gas prices
Import price inflation appears to have peaked
Import prices, foreign export prices and indicators of input cost pressures
Consumer profit margins have been squeezed
Estimated margins on consumer goods and services (a)
The pickup in CPI inflation has largely reflected higher prices for import-intensive components
CPI inflation by import intensity (a)
Unit labour cost growth is expected to have picked up in Q4
Decomposition of four-quarter whole-economy unit labour cost growth (a)
Compositional effects weighed on wage growth in Q3
Estimates of the contribution of employment characteristics to four-quarter wage growth (a)
Pay growth has recovered by more for those switching jobs
Median growth rates of pay (a)(b)
Pay growth has picked up in recent months
Whole-economy regular pay growth (a)
Most survey indicators of pay growth have risen
Indicators of pay growth
Monitoring the MPC’s key judgements
Measures of DGI have been volatile
Measures of domestically generated inflation (a)
Indicators of inflation expectations (a)