UPDATE: Listen to Pete Comley talk about the latest figures on Share Radio:
Inflation data showed a slight rise today to 0.5% CPI and 1.6% RPI. This largely returns it to where it was in March. The primary driver according ONS was a rise in airfares, motor fuels and computer games. The 11% rise in airfares in June might be a temporary blip caused by the Euro championship (or it might be an effect of rising oil prices and the decline in the pound seen even before Brexit). Balanced against this be have been some small declines in accommodation prices (again possibly a Euro effect as people stayed at home more to watch the football) and some declines in furniture costs.
However the biggest drag on prices in the UK remains that world commodity prices. For example, UK food prices are down -2.9% year-on-year and petrol now averages 111p/litre vs 117p a year ago (even though it rose 2% in the latest month). More specifically within food, the largest declines are for vegetables and dairy products (both more than 6% cheaper than a year ago.) Overall goods inflation remains strongly negative (-1.6%) and this is what has kept the overall inflation level low in the last year or so.
The full ONS data can be found here.
The impact of Brexit on CPI (simple model)
A key thing to remember is that the data published today was collected before the Brexit vote and so does not show the impact of the most recent declines of the pound since June 24th.
There is much talk about the effect of the decline in the value of the pound is going to have on the inflation rate. Some commentators have even predicted inflation might go back up towards 5%. This seems unlikely – at least based solely on the current exchange rate – and I expect that the true impact will be much smaller.
If you go back and examine the falls/rises in the value of the pound over the last three decades, you’ll find that there is in fact quite a poor relationship between exchange rate and inflation. Some economists (John Mills for example), even argue that there is no relationship at all. The Bank of England published a report last November which clearly highlighted that the impact of changing exchange rates on inflation very much depends on what is causing the currency change. For example if it is demand-side shock, the inflation rate may not be affected that much.
That being said, the Bank estimate that typically a 10% depreciation in sterling might equate to 2-3% increase in non-energy imported goods prices. Given that these account for just under a third of the CPI index, we might be talking about 0.6%-1% gain in the CPI index. However they also note that the so-called “pass-through” of this increase takes place over a few years (though 60% is normally with the first year).
So what effect might the current declines in the pound have on inflation? Many are focusing on the 10% fall since Brexit, but the pound was declining before that. On a trade-weighted basis, the pound is actually down 18% since its peak last August. That equates to about a 1%-1.8% increase in the index of which maybe just over three-quarters of which will occur before the end of 2017. Taking the mid estimate, CPI might be 1.1% higher next year because of the declines so far in the pound i.e. around 1.6%.
However, it is not impossible that the pound may decline still further over the coming year. Some pundits think it may declines a further 20% to say $1.1 = £1. If that happened, we might be talking of CPI increasing to around 2.8% next year.
Alternative inflation model based on commodity prices
The above analysis is arguably a bit too simplistic. That is because the thing that really drives inflation in this country short-term is commodity prices. The correlation is much higher than anything to do with exchange rates as the following chart illustrates.
Therefore a better question to ask to determine future CPI rates is what we think might happen to world commodity prices than what might happen to sterling.
Where is the oil price going? Pessimists think that the recent decline in the oil price might signal the end of the bounce and is oil now headed lower and back below $30/barrel. However probably a more likely scenario, is that this is but a correction and oil prices continue to rise and maybe stabilise in the $50-$70 area.
Other commodities are also showing signs of revival. World food and beverages prices are up 15% in dollar terms in 2016 so far and almost double that in terms of sterling. Even if they remain at current levels, this is going to force supermarkets soon to at last increase food prices. (Food has declined 2.9% in the last 12 months alone).
Predicting future inflation rates is therefore all about determining the value of goods inflation. In contrast, service inflation in this country has varied little over the recent decades and fluctuates in a narrow range between 2.5%-5%. It is currently at 2.8% and could well edge up to 3.0% to 3.5% in 2017, as the minimum wage rises pass through.
On the other hand, CPI goods inflation has had a very wide range from -2.5% to +7.5%. We are currently at the bottom end of it and due a bounce upwards – see graph.
2017 could well see positive goods inflation return. Assuming commodity prices carry on rising, we might see goods inflation between 0.0% to +2.5%.
So combining this with the service inflation scenario, my prediction for 2017 inflation rate based on commodity prices becomes:
Lower bound estimate
Upper bound estimate
Summary of 2017 CPI prediction
Interestingly these estimates are very similar to those derived from an analysis of exchange rates (range 1.6% – 2.8%). The average of all of the above estimates is around 2.2% CPI for 2017. In other words, inflation could well be back above the 2% target (though its exact amount and trajectory will depend on both what happens to both sterling and oil prices).
The other thing to remember is that it may take a few months before we start to see much of a change in CPI. It is almost certainly going to take a jolt upwards in December, as last year’s oil price declines start to fall out of the calculation. Therefore expect CPI to be 1%+ by year end.
Longer term (the next 2-5 years), the impact of Brexit is even more difficult to predict. Much will depend on how successful the Brexit negotiations are with the EU and probably more importantly what happens to the EU project itself during that time. As I mentioned on Share Radio last month, it is not impossible that sterling could eventually become a safe haven currency if the Euro collapsed. It’s subsequent appreciation could then bring back near-zero inflation again (assuming we’ve not adopted helicopter money by then).