Inflation rate to go negative says BoE – how might that affect you?

The latest Bank of England Inflation Report supports what most people were thinking anyway i.e. that the recent decline in oil prices would create a period of near-zero inflation in the UK. They predict it might happen after the energy companies decrease their prices in March and so will appear in the statistics published on 14th April.

Disposable income up

The most important one is that it will increase disposable income. Estimates vary, but my calculations suggest that the decrease in petrol prices and fuel costs will put an extra £100 a month into hands of every household in the land. Not only does that create a great positive feeling for everyone but it will have knock-on effects on the economy. The BoE Report is predicting GDP growth of 2.9% for the UK in 2015.

Real wage growth – or maybe not

There is much talk about real wage growth returning but I don’t think this will turn out to be quite the case. The argument goes that inflation is now zero but wage growth is 1.7%, so real wages, after inflation, are increasing. But this calculation is flawed on a couple of key counts.

Firstly, it is taking the projected CPI inflation rate for April 2015 and dividing it by the estimated wage growth for October-December 2014, i.e. before the inflation rate really started falling. It has yet to be seen what wage growth will turn out to be in April 2015.

According to YouGov, consumer future inflation expectations are plummeting, as people see more and more headlines talking about deflation. Therefore workers are going to be in a very weak position when they argue for pay rises from now on. Indeed some companies are considering freezing prices or decreasing them as their costs of production have declined. I would not be at all surprised to see average wage growth return to near-zero levels by Q2 2015. Therefore the correct calculation of average wages rises less inflation all based on Q2 2015 data might well show them to be stagnant again.

Secondly, there is another major flaw with this argument. It is using CPI as they key measure of inflation. As I have argued elsewhere, CPI under-estimates real inflation in the UK by around 1-1.5%. Therefore real wages are continuing to decline in the UK, even when CPI is very low.

Thirdly, near-zero wage rises may well persist throughout 2015 and into 2016, as a non-inflationary mindset starts to set in. However by then even CPI will have started to rise again, as the one-off effect of the recent oil price decline is removed from the calculation. Moreover it is not impossible oil prices will recover towards $75 a barrel at some point in 2016 and this could well push CPI back above the 2% target again (and real UK inflation above 3%).

Will low oil prices reboot the UK economy?

The BoE is banking on the boost from lower oil prices helping boost the economy that it reaches escape velocity and the slack is removed allowing productivity and wages to rise. Let’s hope that rose –tinted view materialises. However it is not impossible that the decline in productivity growth is here to stay and wages will not take off. In my view they may well revert again to lagging the rises in CPI inflation and significantly real UK inflation rates.

Enjoy the £100 a month windfall while it lasts.