Bank of England Inflation Report – November 2016

UPDATE:

Listen to Pete talk about the report on Share Radio:

Latest inflation predictions

The latest BoE Inflation Report today showed that the Bank now expects inflation to be higher in the coming years and particularly in 2017. They are now predicting CPI will rise to 2.7% this time next year as opposed to 2% which they said in August. They also increased their inflation predictions for 2018 to 2.7% (2.4%) and do not think it may return to the 2% target until 2020.

Yesterday we had the National Institute for Economic & Social Research (NISER) also raise its forecasts with headlines of 4% predicted inflation next year.

The factors affecting future inflation

There is no doubt that the continued decline in sterling is going to have a significant impact on UK prices. According to the BoE today, the sterling weighted index was down 20% in a year (and it is even more so versus its peak last August). Furthermore, some traders think the current level is a flag on a continued downtrend towards $1.1 and €1 = £1 i.e. a further decline of over 10% at some point during the Brexit negotiations.

It is worth noting though that declines in the pound do not translate simply into rises in the CPI inflation rate. Firstly only a proportion of the prices in the UK are directly influenced by exchange rates – primarily those that are imports or commodity related. These represent about a third of the index. However even here, many importers and companies either choose not to pass all the increases through or may delay doing so (especially if they have forward contracts fixed at pre-Brexit levels).

Pass through depends a lot on the state of the economy and the sectors affected. Usually for motor fuels and gas/electricity prices the pass through is quite quick and in full. In recent days we’ve seen some companies that feel they have bargaining power also pass through the full impact eg Apple and Microsoft. It remains to be seen if the same happens in supermarkets for foods and consumer goods – the Marmite wars indicate pressure is increasing though.

According to Mark Carney today, consumer spending has been so far more resilient than expected post Brexit. That would imply a higher and faster pass through may be attempted on imported goods.

So returning to inflation predictions, next year’s outturn will depend not just on what happens to exchange rates in 2017 but also global commodity prices. Historically, the latter is probably the most influential factor on short term UK inflation rates. Therefore if the oil price was to manage to rise towards $60/barrel this might put even more pressure on CPI than economists are currently factoring in.

Of the two inflation predictions out in the last 24 hours, I expect we’ll see inflation closer to NISER’s 3.8% in 2017 than the Bank’s 2.7%. The Bank has a long track record of predicting inflation two years out will be either exactly at their 2% target or near it. For the vast majority of the decade after 2004, they consistently under-estimated inflation, sometimes by a very wide margin.

Money supply effects on inflation

Another reason to believe inflation is going to run higher in the coming years has not been talked about much in the media. UK inflation over the very long run (i.e. 100 years) has had a strong relationship with the money supply – see here. On Monday we saw figures published showing that the broad UK money supply (M4x) had soared 10% from July-Sept (and 7.7% over the year). Although the pass through of money supply changes is complex, not least because they often go into asset prices first, they will add to continued pressure on UK prices in the years to come.

Implications of the increase in inflation

It is worth considering who is going to win and lose with this burst of inflation.

The key winners are:

  • Government: Tax revenues will rise in line with real inflation (RPI) yet the low interest rates and QE from BoE has ensured that cost of servicing government debt is significantly lower. Furthermore inflation will erode the real value of government borrowings and decrease important debt-to-GDP levels.
  • Other debtors: Major debtors such as corporates and mortgage holders will see the value of their debts decline in real terms. This may well put further pressure on house prices with resulting misery for first-time buyers.

However, for every pound gained by a winner, there is corresponding pound lost by someone eventually. Some of the key losers are:

  • Cash holders: The BoE has ensured interest rates are near zero. If CPI runs at 3-4% CPI for four years (i.e. closer to 4-5% real RPI inflation), purchasing power could be eroded by up to a fifth. That is a staggering level of stealth tax on British companies and savers.
  • Workers: Wages are currently growing at 2.3% a year. That equates to about the current level of RPI inflation (2%). If we see CPI at 4% (RPI = 5%) in 2017, many workers will see a significant decline in their standards of living as wage increases will not keep up. Again compound effects over the coming period of high inflation, could start to have a marked impact on consumer spending – a fact the BoE was highlighting today.
  • Pensions: The impact here is via real bond yields which are the bedrock of most pension savings. The rise in inflation will erode real value of defined contribution pension pots for millions of workers. It may also impact on real annuity rates and more importantly the real value of pensions people receive if they have not inflation protected their annuity.

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