CPI inflation fell to 2.1% in December. The fall over the past year has been partly due to the diminishing effects of the referendum-related sterling depreciation. CPI inflation is expected to dip temporarily below 2% in the coming months, mainly reflecting lower energy price inflation, before rising back above the target in 2020 and remaining a little above 2% as domestic inflationary pressures increase.
4.1 Consumer price developments
CPI inflation was 2.1% in December 2018, having fallen from 3.1% in November 2017, partly due to the diminishing effects of the referendum-related sterling depreciation. Inflation in 2018 Q4 as a whole was 2.3%, lower than forecast in the November Report. That was partly because petrol prices were lower than expected, reflecting the significant fall in oil prices since November. Food price inflation and clothing and footwear price inflation were also slightly lower than expected.
Inflation is expected to fall to 1.8% in January, and to remain just below the target throughout 2019 Q1 (Chart 4.1). That forecast is lower than in the November Report, mainly reflecting the continued impact of lower petrol prices. It also includes the estimated impact of measures announced in Budget 2018. These measures include a freeze in the rate of fuel duty and some alcohol duties, which together reduce inflation by just under 0.1 percentage points from early 2019.
Over the forecast period as a whole, external cost pressures are expected to be lower compared with recent years (Section 4.2). Domestic cost pressures are expected to continue to strengthen (Section 4.3). 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 is expected to fall below the target
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 October, November and December 2018 at the time of the November 2018 Inflation Report. The red diamonds show the current staff projection for January, February and March 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.
4.2 External cost pressures
Changes in wholesale oil and gas prices affect CPI inflation quickly 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.
Dollar oil prices have fallen by 25% since the run-up to the November Report (Section 1), and sterling oil prices have fallen by a similar amount (Chart 4.2). As a result, fuel prices are expected to subtract 0.1 percentage points from CPI inflation in 2019 H1 (Chart 4.3), rather than pushing it up as projected in November. The oil futures curve — on which the MPC’s forecasts are conditioned — is now broadly flat. The projected contribution from fuel prices to CPI inflation further out is therefore a little higher than in November, when the futures curve was downward sloping.
Wholesale gas prices are lower than in the run-up to the November Report (Chart 4.2), but the main near-term influence on retail gas and electricity prices as measured in the CPI is likely to be the introduction of Ofgem’s price cap that affects most standard variable tariffs. As in November, that is expected to reduce CPI inflation by around 0.2 percentage points in 2019 Q1. But the price cap is now expected to be increased in April by more than previously anticipated, reflecting new information provided by Ofgem on its approach to estimating wholesale costs. That means that the projected contribution of gas and electricity prices rises in Q2 (Chart 4.3), pushing CPI inflation back to around the 2% target.
Non-energy import prices
The cost of non-energy imports facing UK companies and households increased substantially after sterling’s referendum-related depreciation in 2016. Import price inflation has fallen back markedly since, as the effect of the depreciation has waned.
The impact of non-energy import costs can be seen in the inflation rates of the more import-intensive components of the CPI basket — those that are imported or have a higher share of imported inputs. These have fallen since their peak in late 2017 as the impact of higher import price inflation has eased (Chart 4.4).
Sterling wholesale energy prices have fallen since November
Sterling oil and wholesale gas prices
- Sources: Bank of England, Bloomberg Finance L.P., Eikon from Refinitiv and Bank calculations.
a Fifteen working day averages to 24 October 2018 and 30 January 2019 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.
Lower energy prices are expected to reduce CPI inflation in the near term
Contributions to CPI inflationa
- 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 Bank staff’s projection. Fuels and lubricants estimates use Department for Business, Energy and Industrial Strategy petrol price data for January 2019 and are then based on the February 2019 Inflation Report sterling oil futures curve, shown in Chart 4.2.
c Difference between CPI inflation and the other contributions identified in the chart.
Inflation among import-intensive components of the CPI has fallen back recently
CPI inflation by import intensitya
- 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. 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 by COICOP class, based on the United Kingdom Input-Output Analytical Tables 2014.
4.3 Domestic cost pressures
Developments in labour costs
Wage growth has continued to strengthen since the November Report amid tight conditions in the labour market (Section 3). Annual growth in whole‑economy regular pay — which excludes the volatile bonus component — averaged 1.5% between 2010 and 2014. But pay growth has since been strengthening, averaging 2.8% in 2018 H1 and 3.2% in 2018 Q3. Regular pay is expected to have grown by 3.3% in 2018 Q4 (Table 4.B), which would be the strongest annual rate of growth since 2008. According to the Bank’s database, median pay settlements rose to 3% in 2018, up from 2% a year ago and 1% two years ago. Some survey indicators of private sector pay growth have also strengthened in recent quarters (Table 4.B). Results from the Bank’s Agents’ annual pay survey are consistent with an increase in pay growth in 2019 (Box 4).
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. Measures of unit labour costs (ULCs) have picked up in recent quarters. Private sector unit wage costs (UWCs) based on the average weekly earnings (AWE) measure of regular pay exclude volatile components such as bonuses and non-wage costs and are also less prone to revision (see the November 2018 Inflation Report for a discussion). That measure rose by 2.1% in 2018 Q3, and monthly data suggest it picked up further to 2.8% in Q4 (Chart 4.5). This is high relative to its post-crisis average growth rate, but probably close to its target-consistent pace. Whole-economy ULCs show a similar picture of rising labour cost pressures. ULC growth on this broader measure was 2.3% in the year to 2018 Q3, and monthly data suggest the growth rate picked up further to 3.1% in Q4.
The composition of the workforce can affect average wage growth if jobs are created or removed in particular occupations, industries, or for certain qualifications. Changes in the composition of the workforce are estimated to have boosted average wage growth by just over ½ percentage point in the year to 2018 Q3, according to Bank staff calculations using Labour Force Survey data (Chart 4.6). If these were to unwind, then wage growth could fall back somewhat in the near term. However, these compositional effects should in principle affect measured wage and productivity growth in a similar way, so they should have less of an effect on ULC and UWC growth.
Growth of private sector UWCs is projected to rise a little further in the near term, supported by continued pay growth.
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 domestically generated inflation (DGI). As explained in previous Reports, there are advantages and disadvantages of each measure and none perfectly captures the concept of DGI.
Most indicators of DGI rose over 2016 and 2017 (Chart 4.7). That is consistent with a gradual building of domestic inflationary pressures over that period, although some of the increase in those indicators was due to higher commodity prices and the effects of the referendum-related sterling depreciation.
By contrast, core services CPI inflation has fallen since mid‑2016. Despite rising slightly in the past few months, it remains some way below its pre-crisis average of 3½%. As discussed in previous Reports, some of the weakness in core services inflation can be explained by lower rents inflation. This partly reflects declining rents paid for social housing, as well as a sharp fall in rents inflation in London. Nonetheless, even excluding rents, core services CPI inflation paints a more muted picture of domestic inflationary pressures (Chart 4.8).
The combination of higher production cost growth and a fall in price inflation suggests that the margins of companies producing consumer goods and services have been squeezed. Margins are difficult to measure, but intelligence from the Bank’s Agents provides corroborative evidence of a recent decline. Contacts reported increasing competitive pressures across a number of different industries and in particular that the growth of online retailing has exerted pressure on the margins of bricks and mortar retailers.
Looking ahead, there may be conflicting pressures on margins. If competitive pressures continue, margins could remain compressed. In aggregate, however, margins tend to be procyclical, and given that some excess demand is expected to build over the forecast (Section 5), they would be expected to increase.1
1 For more details, see Macallan, C and Parker, M (2008), ‘How do mark-ups vary with demand?’, Bank of England Quarterly Bulletin, 2008 Q2.
Monitoring the MPC’s key judgements
Pay growth has continued to strengthen
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 Q4 are Bank staff’s projections, based on data to November.
b Total pay excluding bonuses and arrears of pay.
c Measure 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.
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 and 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 LFS employee job shares. A reading above 50 indicates growth on the previous month and below 50 indicates a decrease.
Unit labour cost growth has strengthened in recent years
Four-quarter unit labour and unit wage cost growth
- Sources: ONS and Bank calculations.
a Private sector AWE regular pay divided by private sector productivity per head, based on the backcast of the final estimate of private sector output. The diamond shows Bank staff’s projection for 2018 Q4.
b 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 Q4.
Compositional effects are estimated to have boosted wage growth in 2018 Q3
Estimates of the contribution of employment characteristics to four‑quarter wage growtha
- Sources: Labour Force Survey and Bank calculations.
a Estimates are shown relative to their averages over 1995 Q1–2010 Q4. Estimates of the effect of individual and job characteristics are derived from a regression of these characteristics on levels of pay using Labour Force Survey data. The estimate of the total compositional effect is obtained by combining these estimates with changes in the composition of the labour force.
b Other includes age, tenure, gender, region of residence, whether working full-time and whether in public sector employment.
Most measures of domestically generated inflation have picked up since 2016
Measures of domestically generated inflationa
- Sources: ONS and Bank calculations.
a 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 Q4; data for the GVA and GDP deflators are to 2018 Q3.
b 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.
Consumer services inflation has fallen, even if rents are excluded
Core services CPI inflation, including and excluding rentsa
- Sources: ONS and Bank calculations.
a Core services CPI is defined in footnote b of Chart 4.7.
4.4 Inflation expectations
Inflation expectations can influence CPI inflation through wage and price-setting behaviour. The MPC monitors a range of indicators — derived from financial market prices and surveys of households, companies and professional forecasters — to assess whether inflation expectations remain consistent with the target.
Indicators of inflation expectations derived from financial market prices increased in 2018 H2 (Table 4.C). UK five‑year inflation swaps five years ahead rose by around 20 basis points, in contrast to dollar and euro equivalents. Market contacts attributed this in part to an increase in demand for inflation protection in the face of Brexit-related uncertainty. This indicator fell back somewhat in January. Market intelligence suggests that was in response to the publication of a House of Lords Economic Affairs Committee report, which made recommendations that would be expected to lower measured RPI inflation if adopted. Despite the recent decline, UK financial market indicators of inflation expectations appear a little elevated.
Other indicators of inflation expectations have generally remained stable (Table 4.C). The projections of professional forecasters remain close to the 2% target. Moves in short‑term and longer-term measures of households’ expectations were generally small. Companies’ inflation expectations fell back to around 2% in Q4.
Overall, the MPC judges that inflation expectations remain anchored, and that indicators of medium-term inflation expectations continue to be consistent with inflation close to the 2% target. The MPC will continue to monitor measures of expectations closely.
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 Financial markets data are averages to 30 January 2019. YouGov/Citigroup data are for January 2019.
c 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.
d In 2016 Q1, the survey provider changed from GfK to TNS.
e CBI data for the distributive trade 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.
f Instantaneous RPI inflation one and three years ahead and five-year RPI inflation five years ahead, implied by swaps.
g Bank’s survey of external forecasters, inflation rate three years ahead.