Published on 10 May 2018
CPI inflation has fallen by more than had been expected in the February Report, to 2.5% in March from 3.0% in December. The impact of sterling's depreciation appears to have diminished slightly more quickly than expected and inflation is projected to fall further towards the 2% target as it continues to diminish. By contrast, domestic cost pressures appear to be rebuilding, supported by rising wage growth.
4.1 Consumer price developments and the near-term outlook
CPI inflation fell to 2.5% in March from 3.0% in December 2017 (Chart 4.1). Although still above the MPC's 2.0% target, that was 0.4 percentage points lower than projected in the February Report. Around 0.1 percentage points of that downside news reflected the effect of the annual update of the CPI component weights by the ONS . The majority of the news, however, reflected the impact of both domestic and external pressures, with lower-than-expected contributions from a range of components within both services and goods.
Goods price inflation, which tends to be relatively import‑intensive, slowed by more than expected in 2018 Q1 (Chart 4.2). That suggests that the effect of the pass-through of higher import prices following sterling's depreciation to CPI inflation has diminished by slightly more than expected, having probably peaked in 2017 Q4. The contribution of that pass-through has accounted almost entirely for the period of above- target inflation since 2016 and is expected to diminish further during the rest of the year (Section 4.2).
Despite the fall in the contribution from import prices, CPI inflation is likely to rise slightly in coming months due to changes in taxation and utility bills. First, the 'Soft Drinks Industry Levy', a tax on companies producing soft drinks with high levels of sugar, is expected to push up inflation by around 0.1 percentage points from April before dropping out of the 12-month comparison a year later. Second, rises in household energy tariffs were announced by some utility companies in April. Those rises are a little larger and sooner than expected in the February Report (Section 4.2).
The path for inflation further ahead will depend on the balance between the diminishing contribution from higher import prices and rising domestic inflationary pressures. Import price growth has continued to slow and the MPC now judges that import prices will push up inflation by somewhat less in coming years than it previously judged (Section 4.2). Domestic inflationary pressures, which had been subdued, are showing signs of picking up and are expected to firm further (Section 4.3). In particular, regular pay growth has continued to rise and is expected to support unit labour cost growth, given subdued productivity growth (Section 3). Inflation expectations, which can influence wage and price‑setting, have been broadly stable and remain consistent with inflation returning to the target in the medium term (Section 4.4).
CPI inflation fell to 2.5% in March
CPI inflation and Bank staff's near-term projection(a)
(a) The beige diamonds show Bank staff's central projection for CPI inflation in January, February and March 2018 at the time of the February Inflation Report. The red diamonds show the current staff projection for April, May and June 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 rise slightly in coming months before falling back further
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.
(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 April 2018 and are then based on the May 2018 Inflation Report sterling oil futures curve, shown in Chart 4.3.
4.2 External cost pressures
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 affect companies' costs. The combined weight of those direct and indirect effects is estimated to make up around 9% of the CPI basket.
Changes in oil prices tend to be passed on to retail fuel prices, and therefore CPI inflation, relatively quickly. The spot price of oil has risen further since February (Section 1) and that will put some slight upward pressure on petrol prices over the next few months. The oil futures curve — on which the MPC's forecasts are conditioned — remains downward sloping, however (Chart 4.3). As such, the contribution from fuel prices to inflation is expected to fall to below average from December 2018.
There was a temporary rise in the spot price of gas in March (Chart 4.3) due to high demand during the period of unusually cold weather (see Box 3). Domestic energy companies tend to agree the purchase of future gas supplies well in advance and so the futures curve, which rose by less, matters more for the price of energy for households.
In April, three large utility companies announced a rise in their prices, which may in part reflect higher wholesale prices from mid-2017 being passed on with a lag. Other providers are expected to announce similar price rises and, as those are implemented in the coming months, the total effect is expected to add around 0.1 percentage points to CPI inflation over the next year, relative to the February Report.
Household utility bills are also likely to be affected by upcoming regulatory changes to caps on standard variable tariff (SVT) accounts. In April, Ofgem increased the existing cap on SVTs for prepayment customers and the Government has proposed a cap on SVT accounts not already capped, expected to be implemented at the end of 2018.
SVTs are the only tariffs captured in the CPI basket, so only changes in those tariffs will be directly reflected in CPI inflation. But, depending on how utility companies react to those changes, there may be effects on other tariffs which could affect energy costs for households and companies. For example, utility companies could seek to maintain their overall margins by increasing the prices of fixed-rate tariffs.
Pass-through of the depreciation of sterling to non-energy consumer prices
Episodes of large exchange rate changes tend to result in sustained movements in inflation away from the 2.0% target. The current overshoot of inflation almost entirely reflects the pass-through of the boost to import prices from the depreciation of sterling which, although volatile since the February Report, remains around 15% below its peak in late 2015 (Chart 4.4).
As set out in previous Reports, Bank staff have estimated that, on average over the past, 60% of changes in the sterling value of non-energy foreign export prices are subsequently reflected in UK import prices, with most of that first-stage pass-through taking around a year. Between 2015 Q4 and 2017 Q4, non‑energy import prices rose by around 10%. That is around half of the rise in foreign export prices in sterling terms (Chart 4.5) and so less than had been expected.
Import price growth slowed in the latest data (Chart 4.5) and a recent survey on corporate pricing by the Bank's Agents has suggested a further easing in import price inflation over 2018. As a result, the MPC now judges that import prices will rise by 55% of the rise in sterling foreign export prices since 2015 Q4, somewhat less than projected in February (Section 5).
The rise in import prices so far appears to have been passed on to consumer prices broadly as expected. Bank staff have estimated that for any rise in import prices, the CPI tends to rise by around 30% of that. That pass-through is gradual, with the peak impact on inflation coming 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, due to the nature of the depreciation since 2015 Q4, the speed of pass-through from import prices to consumer prices was likely to be faster than on average in the past.
The effect of the rise in import prices on CPI inflation can be seen most clearly in more import-intensive components (Chart 4.6). Inflation in those components has slowed in recent months and by more than was expected in February (Section 4.1). That brought the estimated degree of pass-through from the rise in import prices seen so far broadly into line with the MPC's judgement in November 2016, having been slightly above it at the time of the February Report. The effect of import prices on inflation is expected to diminish further over the next couple of years and somewhat more quickly than projected in February, reflecting the lower projected path for import price inflation (Section 5).
The sterling spot oil price has risen slightly further but the futures curve continues to slope downwards
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 31 January and 2 May 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.
Sterling remains 15% below its late-2015 peak
Import prices have risen by around half of the rise in sterling foreign export prices
Import prices and foreign export prices
Sources: Bank of England, CEIC, Eurostat, ONS, Thomson Reuters Datastream and Bank calculations.
(a) Domestic currency non-oil export prices for goods and services of 51 countries weighted according to their shares in UK imports divided by the sterling exchange rate index. The sample excludes major oil exporters. Diamond shows Bank staff's projection for 2018 Q1.
(b) UK goods and services import price deflator excluding fuels and the impact of MTIC fraud. Diamond shows Bank staff's projection for 2018 Q1.
Firms have passed on rising import costs to consumer prices
CPI inflation by import intensity(a)
Sources: ONS and Bank calculations.
(a) Higher import-intensive and lower import-intensive CPI components comprise the top half and bottom half respectively of CPI components by weight ordered by import intensity. Excluding fuel and administered and regulated prices. Data are adjusted by Bank staff for changes in the rate of VAT, although there is uncertainty around the precise impact of those changes. Import intensities are ONS estimates of the percentage total contribution of imports to final household consumption in the CPI, by COICOP class, based on the United Kingdom Input-Output Analytical Tables 2014.
4.3 Domestic cost pressures
Domestically generated inflation
Inflation depends both on external cost pressures and on domestically generated inflation (DGI), which will be influenced by the degree of spare capacity in the economy. While DGI is not directly observable, there are a number of indicators that are closely linked to that concept, the majority of which rose in the latest data (Chart 4.7). As set out in previous Reports, some of those measures can be affected by changes in sterling's exchange rate. While that had been pushing up some measures, the effect is likely to have diminished in recent quarters.
Given the expected slowing in world export price inflation and the diminishing pass-through from the depreciation of sterling, most indicators of domestic inflation will need to rise further to be consistent with CPI inflation at the MPC's 2% target. With very little slack judged to remain (Section 3), domestic inflationary pressures are projected to continue to build to more normal levels over the next year (Section 5).
Wage growth and unit labour costs
The cost of labour, and in particular wages, is the largest domestic cost facing most companies and so is a significant indicator of domestic inflationary pressures. The impact of labour costs on companies' production costs will depend on unit labour cost (ULC) growth — how fast labour costs are rising relative to productivity. Wage growth has been weaker than expected in recent years, but that has partly been driven by weaker-than- expected productivity growth (Section 3). As such, ULC growth has been less subdued (Chart 4.8) and closer to expectations. Greater-than-expected slack in the labour market, however, appears to have weighed on both wage and ULC growth. As a result, the MPC revised down its estimate of the equilibrium unemployment rate. More recently, as slack has been absorbed the drag on wage growth is easing.
During the financial crisis, unemployment rose sharply, job-to-job flows and resignations fell (Chart 4.9), and on-the-job searches rose. These trends were consistent with a fall in the demand for labour and employees becoming less confident about their job prospects. A greater weight on job security during that period is probably one factor that dampened wage expectations and employee bargaining power. Despite that, wage growth did not fall by as much as productivity growth, so ULC growth was less subdued (Chart 4.8) and companies' margins were squeezed. One possible explanation is that employers tend to avoid cutting pay where possible, preferring to freeze pay even if productivity and revenues are falling. Reflecting that, the share of workers receiving 0% pay rises rose sharply during the crisis (Chart 4.10).
In more recent years, unemployment has fallen back significantly and churn in the labour market has recovered, with the proportion of people moving from one job to another now around its pre-crisis rate (Chart 4.9). That suggests some recovery in confidence among employees in their labour market prospects. As a result, businesses have needed to raise wages for new recruits in order to attract staff. The REC survey, for example, suggests that pay growth has risen for new joiners in recent years (Table 4.A), and the Bank's Agents have reported a greater willingness among companies to increase pay growth for new recruits and key staff. In contrast, as set out in the February Report, data from the Annual Survey of Hours and Earnings suggested that pay growth for those staying in their jobs remained subdued in the year to April 2017.
There are now signs that regular pay growth is starting to rise more broadly as the labour market tightens further. Annual regular pay growth rose to 2.8% in the three months to February and is projected to remain around 2¾% over the rest of the year, broadly as projected in February (Table 4.B). Although there was downside news in the contribution from bonuses, and hence total pay growth, bonuses tend to be volatile. As such, total pay growth is expected to rise a little further during 2018.
In addition to wage growth, ULC growth will also depend on growth in non-wage labour costs. Further increases in minimum contributions for auto-enrolled pensions are projected to push up non-wage labour costs in 2018 Q2 and 2019 Q2 but, as these rises affect only a subset of employees, the impact on aggregate ULC growth is expected to be modest.
Weaker-than-expected growth in output per head in 2017 Q4 meant that ULC growth rose by more than expected in February, consistent with some strengthening in domestic cost pressures over the past few months. And ULC growth is expected to firm over 2018 as pay growth continues to outstrip productivity growth (Section 5).
Most measures of DGI have picked up
Measures of domestically generated inflation(a)
Sources: ONS and Bank calculations.
(a) Unit labour costs (ULCs) are whole-economy labour costs (including self-employment income) divided by real GDP, based on the backcast of the final estimate of GDP. Private sector ULCs exclude general government wages and salaries and employers' social contributions and are calculated by using Bank staff's backcast for output generated in the private sector. Unit wage costs are wages and salaries and self-employment income divided by real GDP, based on the backcast of the final estimate of GDP. 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 except services CPI which are quarterly averages of monthly data.
Unit labour cost growth is expected to have picked up in 2018 Q1
Decomposition of four-quarter whole-economy unit labour cost growth(a)
(a) Whole-economy labour costs as defined in Chart 4.7. The diamond shows Bank staff's projection for 2018 Q1.
(b) Self-employment income is calculated from mixed income, assuming that the share of employment income in that is the same as the share of employee compensation in nominal GDP less mixed income.
Pay growth and churn have picked up as unemployment has fallen
Unemployment rate, job-to-job flows and whole-economy regular pay growth(a)
Sources: ONS and Bank calculations.
(a) Shaded areas show two periods of large changes in unemployment: 2008 Q2 to 2009 Q2 and 2013 Q3 to 2017 Q3.
(b) Number of people who reported being in a job three months ago and report currently being in a job for fewer than three months. Seasonally adjusted by Bank staff.
(c) Four-quarter change in whole-economy total pay excluding bonuses and arrears of pay.
The proportion of workers receiving zero pay rises rose sharply during the crisis
Percentage of contracts with zero pay change(a)
Sources: Annual Survey of Hours and Earnings and Bank calculations.
(a) Percentage of workers across the whole economy receiving zero change in pay in their main job between April of each year. Based on hourly gross earnings excluding overtime obtained by dividing gross pay in the reference week by total hours worked.
Regular pay growth has firmed in recent quarters
Indicators of pay growth
Sources: Bank of England, BCC, CBI, Chartered Institute of Personnel and Development (CIPD), KPMG/REC/IHS Markit, ONS and Bank calculations.
(a) Three-month average growth on the same period a year earlier. Figures for 2018 Q1 are estimated based on data for January and February and Bank staff's projections for March.
(b) Total pay excluding bonuses and arrears of pay.
(c) Measures of expected pay for the year ahead. Produced by weighting together responses for manufacturing, distributive trades, business/consumer/professional services and financial services using employee job shares. Data only available since 2008.
(d) Quarterly averages for manufacturing and services weighted together using employee job shares. The scores refer to companies' labour costs over the past three months compared with the same period a year earlier. Scores of -5 to 5 represent rapidly falling and rapidly rising costs respectively, with zero representing no change.
(e) Pay increase intentions excluding bonuses over the coming year. Data only available since 2012.
(f) Net percentage balance of companies currently facing pressures to raise prices due to pay settlements. Produced by weighting together survey indices for pay settlements for services and non-services using employee job shares.
(g) Produced by weighting together survey indices for the pay of permanent and temporary new placements using employee job shares; quarterly averages. A reading above 50 indicates growth on the previous month and those below 50 indicate a decrease.
Monitoring the MPC's key judgements
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.
Most measures of inflation expectations have been broadly stable and remain close to past averages (Table 4.C). 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.
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.
(c) Financial markets data are averages to 2 May 2018. YouGov/Citigroup data are for April.
(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 manufacturing, business/consumer services and distributive trade sectors, weighted together using nominal shares in value added. Companies are asked about the expected percentage price change over the coming 12 months in the markets in which they compete.
(g) Instantaneous RPI inflation one, three and five years ahead implied from swaps.
(h) Bank's survey of external forecasters, inflation rate three years ahead.