CPI inflation fell back to 2.4% in September, having risen in August. Higher import and energy prices have continued to hold inflation above the 2% target, but these pressures are projected to diminish over coming quarters. Meanwhile domestic inflationary pressures are strengthening, supported by rising wage growth.
4.1 Consumer price developments and the near-term outlook
CPI inflation was 2.5% in Q3, as expected in the August Report. Inflation was volatile within that quarter, however, rising from 2.5% in July to 2.7% in August, before falling back to 2.4% in September (Chart 4.1). That volatility occurred across a number of CPI components, including clothing and footwear.
Movements in retail gas and electricity prices are likely to cause some further volatility in CPI inflation in coming quarters (Section 4.2). Two of the major utility companies raised their retail energy prices in October, which — together with a scheduled rise in the Government's prepayment safeguard tariff — will have increased CPI inflation from that month. Acting in the opposite direction, Ofgem's proposed price cap on standard variable tariffs for retail energy is expected to reduce CPI inflation by around 0.2 percentage points from January 2019, pushing CPI inflation towards the 2% target (Chart 4.2).
The outlook for CPI inflation will also be affected by measures announced in the Autumn Budget. These include a freeze in the rate of fuel duty and some alcohol duties until 2020/21. The estimated impact of these measures will be incorporated into the MPC's February 2019 forecast.
In addition to movements in retail energy prices, the path for inflation over the forecast period will reflect the balance between diminishing external cost pressures (Section 4.2) and rising domestic inflationary pressures (Section 4.3). Current above-target inflation is due to the lingering effects of sterling's earlier depreciation and more recent rises in global energy prices. These pressures are likely to subside in coming years. Meanwhile, domestic inflationary pressures have been building as the labour market has tightened. Whole-economy regular pay growth was stronger than expected three months ago at 3.1% in the three months to August, the highest rate since January 2009. Inflation expectations, which can influence wage and price-setting decisions, remain consistent with inflation returning to the target in the medium term (Section 4.4).
CPI inflation fell back to 2.4% in September
CPI inflation and Bank staff's near-term projectiona
- Sources: ONS and Bank calculations.
a The beige diamonds show Bank staff's central projection for CPI inflation in July, August and September 2018 at the time of the August Inflation Report. The red diamonds show the current staff projection for October, November and December 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.
CPI inflation is expected to fall further towards the target in coming months
Contributions to CPI inflationa
- Sources: Bloomberg Finance L.P., Department for Business, Energy and Industrial Strategy, ONS andn 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 October 2018 and are then based on the November 2018 Inflation Report sterling oil futures curve, shown in (Chart 4.3).
4.2 External cost pressures
Changes in wholesale oil and gas prices affect CPI inflation directly through their impact on petrol prices and domestic gas and electricity bills. They can also have indirect effects on inflation, for example through their impact on production and transport costs, which take longer to feed through to consumer prices.
The sterling spot price of oil had risen by 10% since the August Report, mainly due to a rise in dollar oil prices (Section 1), and was over 40% higher than a year earlier (Chart 4.3). Changes in oil prices tend to be passed on to fuel prices relatively quickly, and these are projected to add 0.3 percentage points to CPI inflation in Q4 (Chart 4.2). The oil futures curve — on which the MPC's forecasts are conditioned — remains downward sloping. That means that the projected contribution from fuel prices to CPI inflation falls from mid-2019.
The gas futures curve has also risen, by 15% since the August Report and by around 40% over the past year (Chart 4.3). Energy suppliers have been increasing their retail gas and electricity prices in response to this pickup in wholesale costs, with two of the largest suppliers raising prices further with effect from October. Retail gas and electricity prices are projected to add around 0.3 percentage points to CPI inflation in Q4 (Chart 4.2).
Acting in the opposite direction, however, Ofgem's proposed cap on most standard variable tariffs (SVTs) is likely to weigh on retail gas and electricity prices. The cap, which is due to take effect by the end of the year, is expected to reduce CPI inflation by around 0.2 percentage points from January 2019. Since SVTs are the only gas and electricity tariffs currently captured in the CPI basket, only changes in these tariffs will be directly reflected in CPI inflation.
Under current plans, the cap will be updated twice a year, in April and October. The MPC's forecasts reflect an assumption that the level of the cap will vary with underlying costs, including wholesale energy prices. Given recent rises in wholesale costs, the cap is projected to increase during 2019.
Non-energy import costs
The prices of UK goods and services are affected by the cost of non-energy imports. Sterling's referendum-related depreciation, as well as rises in world export prices, have raised the cost of non-energy imports facing UK companies and households since 2016.
Changes in the sterling value of foreign export prices tend to be reflected in UK import prices within a year. As such, import price inflation has fallen back in recent quarters as the effect of the depreciation has waned, although it is expected to pick up a little in Q3 (Chart 4.4).
The rise in import prices following sterling's referendum-related depreciation is in turn being passed through to consumer prices. That effect has been especially apparent in the prices of import-intensive CPI components such as food and other goods. While the pass-through of import prices to retail prices tends to take time, the impact of the depreciation on CPI inflation is likely to have peaked. Consistent with that, non-energy goods price inflation has slowed in recent months. The effect of import prices on CPI inflation is set to diminish further over the forecast horizon (Section 5), despite further rises in import prices in the near term (Table 4.A).
Sterling wholesale energy prices have risen further since August
Sterling oil and wholesale gas prices
- Sources: Bank of England, Bloomberg Finance L.P., Datastream from Refinitiv and Bank calculations.
a Fifteen working day averages to 25 July and 24 October 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 elevated rates
Import prices and foreign export pricesa
- Sources: Bank of England, CEIC, Datastream from Refinitiv, Eurostat, ONS and Bank calculations.
a The diamonds show Bank staff's projections for 2018 Q3.
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 Domestic cost pressures
In addition to external cost pressures, the path for CPI inflation will depend on domestically generated inflation (DGI). Having been subdued, domestic inflationary pressures have been rebuilding as slack in the economy has been absorbed.
Developments in labour costs
Labour is the largest domestic cost facing most businesses in the UK, and so is an important indicator of domestic inflationary pressures. The extent to which changes in the cost of labour affect companies' production costs, and hence CPI inflation, depends on growth in unit labour costs (ULCs) — how wages and other labour costs facing companies are growing relative to productivity.
Wage growth has continued to firm as the labour market remains tight and unemployment has fallen (Section 3). Whole-economy regular average weekly earnings (AWE) growth — which excludes the volatile bonus component — is expected to have been 3.1% in Q3 (Table 4.B), 0.4 percentage points higher than anticipated in August. That was also stronger than in 2016, when growth averaged around 2½%, and stronger still than in 2010–15 when it averaged around 1¾% per year. Data from the latest Annual Survey of Hours and Earnings — which relate to April 2018 — suggest that pay rises have broadened out a little from workers switching jobs to those remaining in their jobs (Chart 4.5).
The pickup in whole-economy wage growth reflects a strengthening in both public and private sector pay. Public and private sector regular pay growth picked up to 2.7% and 3.1% respectively in the three months to August, around 1 percentage point higher than a year earlier. Most survey indicators of private sector pay growth have also strengthened in recent quarters (Table 4.B).
While wage growth has strengthened, it remains below the rates seen on average prior to the crisis, when regular pay grew by around 4% per year. That is largely the result of continued weak growth in productivity (Section 3) — the amount produced per worker — which has reduced the wage rises that companies can afford to offer their employees. That weakness in productivity growth has in turn boosted growth in whole‑economy ULCs relative to the pre-crisis period (Chart 4.6). Whole-economy ULC growth has picked up in recent years and was 2% on average over 2018 H1. That was weaker than expected in August, however, due to revisions to the ONS measure of wages and salaries.
In addition to whole-economy ULCs, there are a number of other measures of labour costs which may at times provide a better indication of DGI (Table 4.C). Measures based on AWE pay growth, for example, are less prone to revision than those based on total labour costs. And those based on AWE regular pay growth also exclude non-wage labour costs and bonuses, both of which can be volatile. These components weighed on whole-economy ULC growth over the first half of 2018. As a result, whole-economy regular pay-based unit wage cost growth was a little stronger than ULC growth, at 2.4% on average in the first half of 2018 (Chart 4.7).
Measures based solely on private sector pay have a number of additional advantages. Private sector pay forms a larger share of costs for producers of consumer goods and services, and so is likely to have a stronger relationship with CPI inflation. In addition, public sector output, and hence productivity, can be difficult to measure accurately. As explained in the box on page 21 of the May 2012 Report, many public services are provided free at the point of delivery, so there is no direct measure of the prices of public services that can be used to deflate nominal government expenditure. Private sector AWE regular pay-based unit wage cost growth strengthened from 1.8% in 2016 to 2.1% over the first half of 2018 (Chart 4.7).
Growth in whole-economy and private sector measures of labour costs are projected to rise over the forecast period, supported by robust growth in regular pay. That leads to a gradual building of domestic inflationary pressures (Section 5).
Other measures of domestically generated inflation
In addition to the different indicators of unit labour and wage costs, there are a number of other measures linked to the concept of DGI. As explained in previous Reports, there are advantages and disadvantages of each measure and none perfectly captures the concept of DGI.
Most of these measures have strengthened since early 2016 (Chart 4.8), consistent with a gradual building in domestic inflationary pressures over that period. One exception to that trend, however, has been CPI services inflation. Core services CPI inflation, which excludes components that are more likely to be related to tradable prices or government policy such as airfares and education, fell from an average of around 2½% during 2016 to 2% in 2018 Q3. Part of that fall is likely to reflect factors that do not truly represent domestic inflationary pressures, however. To the extent that service providers use imported goods and services as inputs, for example, some of the recent fall may reflect the diminishing effect of sterling's past depreciation.
Part of the weakness in core services CPI inflation also reflects unusually low rent inflation, which was 0.5% in Q3, compared with around 3% in early 2016. Rent inflation tends to be less directly affected by slack in the economy or external cost pressures, and is more likely to reflect developments specific to the housing market. Around half of the slowing since early 2016 can be accounted for by lower rents paid for social housing, which in turn is likely to have reflected the Government's policy to reduce rents for most social housing tenants. Rent inflation is projected to remain subdued in coming months, and — since rents account for around 20% of the core services CPI basket — core services CPI inflation is also expected to remain relatively subdued, despite building labour cost pressures.
Pay growth has continued to firm
Indicators of pay growth
- Sources: Bank of England, 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 Q3 are Bank staff's projections, based on data to August.
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 from Workforce Jobs. Data for financial services only available since 2009 Q1, and other sectors since 2008 Q2.
d Quarterly scores 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 Quarterly averages for the pay of permanent and temporary new placements weighted together using employee job shares. A reading above 50 indicates growth on the previous month and below 50 indicates a decrease.
Pay growth has picked up a little for those staying in their jobs
Median annual growth rates of paya
- Sources: Annual Survey of Hours and Earnings and Bank calculations.
a Pay growth is median annual growth rate in April. Based on hourly gross earnings obtained by dividing gross pay in the reference week by total hours worked. Workers moving jobs are defined as workers in employment in consecutive years in a different job. Workers moving employers are defined as workers in employment in consecutive years with a different employer.
Unit labour cost growth has strengthened in recent years
Decomposition of four-quarter whole-economy unit labour cost growtha
- Sources: ONS and Bank calculations.
a Whole-economy labour costs divided by real GDP, based on the backcast of the final estimate of GDP. The diamond shows Bank staff's projection for 2018 Q3.
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.
All measures of unit labour cost growth have strengthened in recent years
Measures of unit labour costs (ULCs) and unit wage costs (UWCs)a
- Sources: ONS and Bank calculations.
a Based on the backcast of the final estimate of real GDP, or private sector output in the case of the private sector measures. Measures are defined in Table 4.C. The pre-crisis periods are defined as 2001–07 for the AWE-based measures and 1998–2007 otherwise.
Core services CPI inflation has fallen in recent quarters
Measures of domestically generated inflationa
- Sources: ONS and Bank calculations.
a 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 except core services CPI which are quarterly averages of monthly data. Data for core services CPI and services PPI are to 2018 Q3; data for the GVA and GDP deflators are to 2018 Q2.
4.4 Inflation expectations
Inflation expectations can influence CPI inflation through wage and price-setting behaviour. If employees and companies became less confident that CPI inflation would fall back to the MPC's 2% target, for example, that might alter wage and price-setting decisions and 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. Measures derived from financial market prices have risen gradually in recent quarters (Table 4.D). According to market contacts, those rises may have been partly due to growing demand for protection against elevated inflation outturns in the face of Brexit-related uncertainty.
By contrast, measures of households' and companies' inflation expectations have been broadly stable, and most remain close to their past averages (Table 4.D). Professional forecasters' expectations have fallen slightly. 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 expectationsa
- 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 24 October 2018. YouGov/Citigroup data are for October.
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 by swaps.
h Bank's survey of external forecasters, inflation rate three years ahead.
There are a number of different measures of unit labour and wage costs
Comparison of unit labour and wage costs
- a Employers' social contributions.
b 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.
c Calculated as whole-economy labour or wage costs divided by GDP.