Commodities / sterling obscure 2%+ UK domestic inflation

13th January 2015 by The Harried House Hunter

UK annual consumer price inflation fell from 1.0% in November to 0.5% in December (0.55% before rounding). The decline was entirely due to a faster rate of decline of energy prices – down an annual 5.8% in December versus 0.2% in November*. “Core” inflation – excluding energy, food, alcohol and tobacco – recovered to 1.3% last month from 1.2% in November.

This core measure understates domestic inflationary pressure because it incorporates a drag on prices of tradeable goods and services (excluding energy and food) from sterling strength in 2013 and the first half of 2014. Non-energy industrial goods prices fell by an annual 0.3% in December; without sterling’s appreciation, they might have risen by about 1%**. This suggests a negative impact on core inflation of about 0.5 percentage points***.

Sterling’s effective rate has stabilised since mid-2014 and manufactured import prices have started to recover, rising an annual 1.0% in November versus a 4% fall in March. This may be reflected in firmer consumer prices of non-energy industrial goods in early 2015.

Bank of England research confirms a large drag effect from the exchange rate on current inflation. In a speech in October, MPC member Kristin Forbes reported simulations on the Bank’s COMPASS model suggesting that 2013/14 sterling strength would cut CPI inflation by about 1 percentage point by end-2014, up from about 0.4 percentage points in the first quarter

An alternative approach to gauging domestic inflationary pressure is to focus on services inflation, which is less affected by changes in commodity prices and the exchange rate, although not impervious****. Annual services inflation was 2.3% in December versus 2.4% a year earlier.

The official consumer prices index (CPI) excludes owner-occupiers’ housing costs. The alternative CPIH measure includes such costs using a “rental equivalence” approach, but the Office for National Statistics has stated that its estimates of rental inflation are biased downwards. It recently started to publish an alternative series for owner-occupiers’ costs based on the “net acquisitions” approach; this rose by an annual 4.1% in the third quarter – see previous post for more details. An alternative measure of services inflation incorporating this series using the relevant CPIH weight stood at 3.0% in the third quarter.

The suggestion that domestically-generated inflation is above 2% is supported by recent national accounts prices data, with the caveat that these are subject to revision. The deflator for “gross value added at basic prices” – a measure of prices of domestically-produced goods and services sold both in the UK and overseas – rose by an annual 2.4% in the third quarter.

*The energy weight is 8.0%, implying an impact of -0.45 percentage points.
**Annual inflation averaged 1.0% over 2010-14.
***Based on a 39.7% weight of non-energy industrial goods in the core basket.
***Examples of effects include foods costs on catering services, energy costs on transport services and the exchange rate on foreign holidays.

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