Why has UK CPI inflation fallen and will the improvement be sustained? The view here is that the recent decline is a lagged response to economic weakness in 2011-12, which in turn reflected insufficient money supply expansion in 2010-11. Monetary trends recovered strongly in 2012-13, laying the foundations for the current economic boomlet and a probable revival in price pressures in 2014-15.
The monetarist rule is that money supply changes filter through to inflation with a long and variable lag averaging about two years. The first chart shows that trend changes in broad money growth over the last decade have preceded sustained swings in core CPI inflation in the same direction by about two years, consistent with the rule.
Broad money growth bottomed in August 2011, rising strongly through early 2013. Based on the average two-year lead, this suggested that core inflation would reach a low in late 2013 and revive during 2014 – see post from September. The decline, in fact, has continued into early 2014, partly reflecting recent exchange rate appreciation. Unless sterling strengthens further, however, a turning point is likely to be evident by the spring.
The second chart shows illustrative projections for core and headline CPI inflation based on the rise in broad money growth over 2011-13 and reasonable assumptions about energy and unprocessed food prices and student tuition fees*. The headline rate is forecast to fall slightly further in February / March before reviving to end the year at about 2.75%. Such a rise, of course, would shock the Bank and undermine its new forward guidance.
Business survey pricing plans are consistent with an imminent inflation trend change. The third chart shows the headline CPI rate together with an average of price expectations balances from the EU Commission surveys of services, manufacturing, retail and construction. The survey measure has firmed since mid-2013, with the January reading the strongest since May 2011.
The suggestion that inflation is bottoming is also supported by the alternative RPIJ measure, based on the components and weights of the RPI and the CPI’s calculation method. This measure revived from a low of 1.9% in October to 2.1% in January. The recent divergence with CPI inflation is due partly to RPIJ’s inclusion of housing costs but mostly to other coverage differences. RPIJ is considered a superior measure of UK wage-earner inflation, since its population base excludes the top 4% of the income distribution, pensioners mainly dependent on benefits and foreign visitors.
*Domestic energy, motor fuel and unprocessed food prices rise by 3% per annum while tuition fees have the same upward impact on the CPI in October 2014 as in October 2013.