UK inflation: stubborn “core” pressures at odds with consensus optimism

UK consumer price inflation fell to an annual 4.2% in December as energy and food prices slowed and the effects of last year’s VAT hike started to drop out of the comparison. This decline does not represent a favourable surprise, having been widely predicted for several months. (A 4.2% end-year headline rate was forecast here in the summer.)

CPI inflation has been above the 2% target in every December since 2005.

The Bank of England’s claim that CPI inflation will slow dramatically during 2012, ending the year below target, has, like its earlier optimistic forecasts, been accepted by the consensus – the median projection for the first quarter of 2013 is 1.9%, according to Consensus Economics. This, however, requires a significant decline in “core” price momentum and / or further weakness in global commodity prices. Neither is likely.

The first chart below shows one measure of core prices – the CPI excluding unprocessed food and energy incorporating an attempt to strip out recent VAT effects and adjusted for seasonal factors. The 12-month increase in this measure rose to a two-year high of 2.6% in December. Six-month momentum of smoothed prices was slightly lower at 2.5%, having been stable during the second half of 2011, showing no response to economic weakness.

The six-month momentum measure has remained at or above 2% since January 2008. Having failed to rachet lower in the wake of the “great recession”, it is unclear why it should suddenly drop now.

If core inflation remains resilient, forecasts of a sub-2% headline rate will depend on a big drag from food and energy prices. Food should have a favourable impact but energy and other industrial commodities tend to correlate with emerging-world economic activity, which is now reviving. The second chart shows the six-month change in the Journal of Commerce industrial commodity price index together with a leading indicator for the “E7” emerging economies. The leading indicator has recovered to a level historically consistent with rising raw material costs.

The third chart show an inflation forecast based on stability in core price momentum and energy prices coupled with a fall in unprocessed food price inflation to 1% by mid-2012. It also incorporates a 0.2 percentage point upward impact from university tuition fees from October. Headline CPI inflation is projected to finish 2012 at 2.6% having touched an interim low of 2.4% in August.

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  • Anonymous

    Thanks, Simon for this illuminating post. Do you also worry about the effective sterling exchange rate viz stubborn inflationary influences?

  • Pavlo

    I do wonder why we are not seeing a beneficial effect of sterling’s improvement reflected in food prices ( mainly from Euro zone ) and energy prices? Profiteering?

  • Simon Ward

    Shire, The low level of the real exchange rate is probably contributing to the stubborn core trend but it may also reflect expectations becoming detached from the target. Regards, Simon

  • Simon Ward

    Pavlo, Sterling hasn’t recovered much in trade-weighted terms and has fallen versus the US dollar.