CPI inflation was at the 2.0% target in June.
Inflation is projected to fall below the target over the next six months as energy prices decline.
From next year inflation is expected to pick up as the impact of lower energy prices fades, sterling’s recent depreciation pushes up import prices, and domestic inflationary pressures rise.
4.1 Recent developments and the near-term outlook
CPI inflation was 2.0% in June, in line with the forecast in May (Chart 4.1). Inflation has been close to the target for the past few months after declining through much of last year as the boost from sterling’s earlier depreciation faded.
Inflation is expected to fall below the 2% target in the near term largely due to a weaker contribution from energy prices (Section 4.2). Petrol prices are expected to decline, so the contribution of fuels and lubricants to CPI inflation turns negative. Similarly, retail gas and electricity prices are expected to fall in Q4 as recent falls in wholesale prices lead to a reduction in the Ofgem energy price cap. Core inflation, which excludes the effects of energy and other volatile components such as food, was 1.8% in June, and is expected to be at similar rates over much of the next six months (Chart 4.2).
Core services price inflation has increased slightly in recent months, in part because unusually weak contributions from car insurance and rents are beginning to fade. This gradual pickup is expected to continue over the forecast as domestic inflationary pressures build (Section 4.3). Those pressures push CPI inflation slightly above the target in the medium term (Section 5).
Developments in inflation expectations, which can influence wage and price-setting decisions, have been mixed but remain consistent with inflation being around the target in the medium term (Section 4.4).
CPI inflation is expected to fall below the 2% target in the coming months
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 April, May and June 2019 at the time of the May 2019 Inflation Report. The red diamonds show the current staff projection for July, August and September 2019. 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.
Energy prices are expected to drag on CPI inflation in 2019 H2
CPI inflation, core CPI inflation and the contribution of energy
- Sources: Bloomberg Finance L.P., Department for Business, Energy and Industrial Strategy, ONS and Bank calculations.
a Bank staff’s projection. Fuels and lubricants estimates use Department for Business, Energy and Industrial Strategy petrol price data for July 2019 and are then based on the sterling oil futures curve.
b CPI inflation excluding food, energy, alcohol, tobacco and non-alcoholic beverages.
c Contribution of fuels and lubricants and electricity, gas and other fuels to annual CPI inflation.
4.2 External cost pressures
Wholesale oil and gas prices have fallen since the May Report (Chart 4.3). Sterling oil prices are around 6% lower than they were three months ago, and around 9% lower than a year ago.
The fall in the dollar oil price has been even larger, but this has been partially offset by sterling’s depreciation.
Oil prices affect inflation directly through their impact on fuel prices. Petrol and diesel pump prices were a little elevated relative to the sterling oil price in June. This appears to reflect unusually high margins in the retail sector. These have tended not to persist in the past, so both lower wholesale costs and a normalisation of margins are expected to push down fuel prices over the coming months.
Wholesale gas prices — which feed through into retail energy prices with a lag — have fallen by 14% since the May Report (Chart 4.3). Wholesale electricity prices have fallen by 2%. These wholesale prices are an important part of retail energy companies’ costs and are used by Ofgem to calculate the energy price cap that affects some common tariffs. Given the recent fall in wholesale costs, the cap — which is reviewed twice a year — is projected to fall in October. Retail gas and electricity prices are consequently projected to drag on CPI inflation in Q4, causing the total contribution of energy to inflation to swing from 0.4 percentage points in Q2 to -0.2 percentage points in Q4 (Chart 4.2).
The MPC’s August projections assume that oil, gas and electricity prices will remain flat after two quarters such that they make a neutral contribution to inflation in the later part of the projections. That is a change from previous forecasts in which they were assumed to follow the futures curves. The reasons for this change are outlined in Box 5.
Non-energy import prices
Import price inflation has been relatively subdued over the past year (Chart 4.4), following high rates over 2016 and 2017 after sterling’s referendum-related depreciation.
The past increase in import prices associated with the 2016 depreciation appears to have largely been passed through to consumer prices. The inflation rate of import-intensive CPI components — those which are imported or have a higher share of imported inputs — has fallen back from its 2017 peak (Chart 4.5). The impact of higher import prices on CPI inflation appears to have faded somewhat faster than had been expected previously. As discussed in a box in the November 2015 Report, the effect of imported price pressures on consumer prices varies over time and will depend on the factors driving the change in the exchange rate.
Sterling has depreciated by around 4% since the May Report (Section 1), which will lead to higher import prices in the future. The outlook for inflation will continue to be sensitive to movements in the exchange rate, which in turn will remain sensitive to Brexit developments. Box 6 in Section 5 sets out how the MPC’s projections for growth and inflation might be different under alternative paths for the exchange rate and other asset prices.
Sterling oil prices and wholesale gas prices have fallen since May
Sterling oil and wholesale gas prices
- Sources: Bloomberg Finance L.P., Eikon from Refinitiv and Bank calculations.
a US dollar Brent forward prices for delivery in 10–25 days’ time converted into sterling.
b One-day forward price of UK natural gas.
Import price inflation was close to zero in the year to Q1
Import prices and foreign export price inflationa
- Sources: Bank of England, CEIC, Eikon from Refinitiv, Eurostat, ONS and Bank calculations.
a The diamonds show Bank staff’s projections for 2019 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.
Inflation among import-intensive components has fallen back from its 2017 peak
CPI inflation by import intensitya
- Sources: ONS and Bank calculations.
a Higher and lower import-intensive CPI components are the top and bottom half respectively of CPI components ordered by import intensity. Data exclude fuel and administered and regulated prices and 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
The growth of labour costs — which are an important part of many companies’ overall costs — has picked up (Section 3). The extent to which the cost of labour affects companies’ production costs per unit of output depends on how it is growing relative to productivity. Those unit labour costs have grown slightly faster in recent years as wage growth has strengthened and productivity growth has weakened (Chart 4.6).
Unit labour cost measures can be used as indicators of domestically generated inflation (DGI). The recent pickup in labour cost growth means that these measures are now towards the top end of ranges estimated to be consistent with CPI inflation at the target.
Some price-based measures of DGI have been more stable, and remain below or towards the bottom end of their target-consistent ranges. Core services inflation focuses on a subset of the CPI basket that is largely domestically produced, as well as excluding some volatile components such as airfares. This measure has risen a little in recent months, but remains low by historical standards. It has been depressed recently by particular weakness in a small number of components, notably car insurance and rents (Chart 4.7). The unusual weakness in insurance price inflation has begun to ease and is expected to dissipate in the next few months. The weakness in rents inflation is likely to persist for a little longer; although private sector rents inflation has begun to pick up, most social housing rents cannot be increased until April 2020.
The rate of core services price inflation that is consistent with overall inflation at the target is uncertain. Before the crisis, goods prices fell on average (Chart 4.7). This meant that the target-consistent rate of services price inflation was substantially above 2%. Although goods prices are likely to continue to get cheaper relative to services, the pace of relative decline is likely to be lower than pre-crisis for several reasons. First, the prices of imported goods fell in the pre-crisis period as several large emerging economies integrated into global supply chains. This is not expected to be repeated, so import prices are expected to rise in the future. Second, productivity in industries which produce goods increased much faster than in the service sector in the pre-crisis period, but this differential has been much smaller recently. Third, the measurement of clothing price inflation has changed — bringing it more in line with standard practice — such that it is likely to be higher now than before the crisis. Altogether, this means that the rate of services price inflation consistent with the target is likely to be lower than pre-crisis. However, it is hard to know precisely how much lower it will need to be.
Several other price-based measures of DGI have picked up since 2015, although trends over the past year have been varied. The median inflation rate of the CPI’s services items — a measure of services price inflation less affected by volatility in individual items — suggests that DGI has increased gradually since 2015 (the blue line in Chart 4.8). A measure of inflation using only labour-intensive services suggests DGI picked up more sharply after 2015, but has fallen slightly over the past two years (the red line in Chart 4.8). Measures based on prices which have been relatively responsive to wage growth or the output gap in the past have also picked up in recent years, but have been fairly stable lately.1
Although these measures are all constructed differently, ultimately all of them put a lot of weight on price inflation in different parts of the services sector. However, there are reasons why goods prices may also be informative about domestic inflationary pressures. Goods prices adjust more frequently than services prices, with 24% of goods prices changing every month compared with only 9% of services prices.2 Although this probably reflects a need to adjust more frequently to external cost pressures, it may also reveal domestic inflationary pressures at an earlier stage if the influence of external factors can be identified and removed.
In the MPC’s central projection, domestic inflationary pressures are projected to build gradually over the latter part of the forecast period (Section 5). This is expected to be accompanied by stronger growth in the various price-based indicators of DGI.
Unit labour cost growth has strengthened in recent years
Contributions to four-quarter private sector unit wage cost growtha
- Sources: ONS and Bank calculations.
a Private sector AWE regular pay divided by private sector productivity per head, based on the backcast for the final estimate of private sector output. The diamond shows Bank staff’s projection for 2019 Q2. See Table 4.C in the November 2018 Inflation Report for more details.
Core services price inflation remains low by historical standards
Core goods and core services CPI inflationa
- Sources: ONS and Bank calculations.
a Core services CPI excludes airfares, package holidays, education and VAT. Core goods CPI excludes food, non-alcoholic beverages, alcohol, tobacco, energy and VAT. Where Bank staff have adjusted for the rate of VAT there is uncertainty around the precise impact of those changes.
Price-based indicators of DGI have picked up since 2015
Indicators of domestically generated inflation
- Sources: ONS and Bank calculations.
a Labour-intensive services CPI contains the top 15 components of core services CPI by labour content, assessed using the United Kingdom Input-Output Analytical Tables 2014. Data are adjusted by Bank staff for changes in the rate of VAT, although there is uncertainty about the precise impact of those changes.
b The median annual inflation rate of around 190 services items in the CPI basket. These data have not been adjusted for changes in the rate of VAT.
4.4 Inflation expectations
Domestic wage and price-setting behaviour can be affected by people’s expectations about the likely future rate of inflation. If companies expect average prices to rise more quickly, they may increase their own prices by more, for example.
The MPC monitors a range of indicators of inflation expectations — derived from financial market prices and surveys of households and companies — to assess whether they remain consistent with the 2% target.
Measures of inflation expectations derived from financial market indicators increased over 2018 H2 and have remained above their historical averages in 2019 (Table 4.B). This is in contrast to similar measures in the US and euro area, which have fallen (Section 1).
The increases in shorter-term financial market measures may reflect expectations about the economic impact of Brexit. Some Brexit outcomes could involve tariffs and a sterling depreciation and hence higher import prices. All else equal, these would push up inflation over the next few years.
There may also be market-specific factors affecting these measures. Financial market expectations are for RPI inflation, so can be affected by changes in the expectation for the wedge between RPI and CPI inflation. In addition, the UK’s Debt Management Office has issued fewer index-linked gilts since the start of 2019 than in previous years. This reduction in supply may be pushing up the price of index-linked securities, boosting implied inflation expectations.
Developments in the inflation expectations of households and firms have been mixed, but they are generally closer to their post-crisis averages.
The latest Bank/TNS survey of households suggested that expectations for inflation in one and two years’ time were broadly stable in 2019 Q2, and close to their average levels since 2010 (Table 4.B). Expectations for inflation in five years’ time picked up to the highest level since the survey began in 2009. But there was no material increase in either the YouGov/Citigroup or the Barclays Basix surveys at that horizon. Inflation expectations across the various surveys remain higher than the 2% CPI inflation target on average, possibly as a result of respondents referring to a different price index such as the RPI. Differences in spending patterns and cognitive biases may also contribute.3
Inflation expectations among companies have fallen slightly, with respondents to the CBI Distributive Trades Survey expecting below-average inflation over the next year. The inflation expectations of professional forecasters rose slightly in Q3, and are in line with the 2% target (Box 7).
Overall, the MPC judges that inflation expectations remain anchored. The MPC will continue to monitor measures of expectations closely.
1. For example, see Figure 8 in Saunders, M (2019), ‘The economic outlook’.
2. For more details, see Bunn, P and Ellis, C (2011), ‘How do individual UK consumer prices behave?’, Bank of England Working Paper No. 438.
3. For more details, see Tenreyro, S (2019), ‘Understanding inflation: expectations and reality’.
Monitoring the MPC’s key judgements
Financial market measures of inflation expectations are elevated, but households’ expectations are generally close to their post-crisis averages
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 Averages from 2000, or start of series, to 2007. Financial market data start in October 2004, YouGov/Citigroup data start in November 2005 and professional forecasters data start in 2006 Q2.
c Financial market data are averages to 24 July 2019.
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 trades sector. Companies are asked about the expected percentage price change over the coming 12 months and the following 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.
Box 5 The assumptions for energy prices in the MPC’s projection
In order to produce its forecasts for GDP growth and inflation, the MPC makes assumptions about the future path of energy prices. The MPC has decided to change these assumptions for this and future Reports to make the forecast simpler and more transparent. This box provides more detail about the changes.
Energy prices — made up of fuel and utility prices — directly account for 6% of the CPI basket. They also have an indirect effect on inflation because energy is used as an input in the production of other items in the basket. And there is a further indirect effect on both inflation and GDP growth via their impact on real household incomes and demand.
In previous Reports, the MPC has assumed that the wholesale costs of oil, gas and electricity follow their respective futures curves. The futures price of an asset is the price of entering into a contract today to buy or sell the asset on some agreed future date. The set of prices for all future dates form the futures curve. The futures curve cannot be directly interpreted as financial market participants’ expectations for spot prices because risk premia and other factors, such as storage costs, can affect futures prices. But expectations do play a major role.1
In this Report, the MPC has assumed that the wholesale prices of oil, gas and electricity remain unchanged over much of the forecast period. The MPC’s near-term forecasts for the next two quarters will continue to assume that wholesale prices follow the futures curve, but beyond that they are assumed to remain flat.2
Chart A illustrates this change for oil prices. In the May Report, the futures curve was downward sloping, which mechanically implied that oil prices fell over the forecast. In this Report, the MPC is assuming the oil price remains flat over much of the forecast period.
Wholesale costs are the dominant driver of fuel and utility prices, so this change affects the MPC’s inflation forecast. Given the downward-sloping oil futures curve at the time of the May Report, wholesale costs dragged on CPI inflation throughout the forecast. In the August Report, the assumed path for oil prices is flat, such that wholesale costs are projected to make a broadly neutral contribution to inflation after 18 months. Overall, the change pushes up the inflation forecast by 0.1 percentage points relative to May at the end of the second and third years of the forecast.
The main advantage of the new assumption is simplicity. The assumption that wholesale prices are flat after two quarters means the contribution of energy prices to inflation in the later years of the forecast will not change as much between forecasts. That will make the key judgements underlying the MPC’s inflation forecast clearer. Moreover, there is little to choose between the two methodologies in terms of forecast performance.
1. For a discussion of the information content of the oil futures curve, see Nixon, D and Smith, T (2012), ‘What can the oil futures curve tell us about the outlook for oil prices?’, Bank of England Quarterly Bulletin, 2012 Q1.
2. Longer-dated futures prices will still be used to forecast changes in Ofgem’s energy price cap, which uses futures prices for 12 months forward in part of the calculation.
The MPC now assumes that oil prices will be unchanged over the forecast after two quarters
Assumptions about oil prices in the May and August Inflation Reports
- Sources: Bank of England, Bloomberg Finance L.P., Eikon from Refinitiv and Bank calculations.
a US dollar Brent forward prices for delivery in 10–25 days’ time.
b Fifteen working day average to 24 April 2019.
c Based on monthly Brent futures prices for two quarters, then held flat. Fifteen working day average to 24 July 2019.