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Point of View

Inflation: Why we expect little change in the medium term

Francois Kotze, Assistant Fund Manager

UK inflation may persist above 2.5% for the rest of the year, but we expect it to fall back towards the Bank of England’s target of 2% throughout 2018. This should keep interest rates on hold for the foreseeable future.

When thinking about the inflation picture and how it translates to interest rates, it is important to consider the domestic drivers of inflation which the Bank of England can influence, and the external drivers over which it has little control.

The most recent inflation numbers surprised on the downside. The consumer price index increased by 2.5% over the year, compared to a 2.6% expectation. This was driven by slightly cheaper prices at the pump for motorists. Unfortunately for those of us that take the train to work, retail price index increased by a little bit more than expected at 3.6% versus one year ago, and this will translate into rail fares rising by the same amount.

When you step back from the month on month changes in inflation though, the UK inflation picture has been driven by large external forces over which the Bank of England has little control, but ensures inflation remains fairly predictable.

In very general terms, the 2015 inflation story was driven by oil prices falling drastically. Inflation was 0.2% that year, although excluding food and fuel it was 1.4%. The Bank of England wasn’t overly concerned with these low numbers, as they viewed this as a transitory external impact that wouldn’t (and didn’t) impact the longer-term inflation picture.

In 2016 inflation was heading back to target as the impact from oil price declines was fading. The UK’s vote in the EU referendum then sent Sterling sharply down versus our major trading partners. UK producer prices – the cost of production for UK companies – went sharply higher very quickly, and much of 2016 and 2017 has been about producers passing those higher costs through to consumers, leading to inflation rising from almost zero in 2015 to almost 3% in 2017.

 

Negative real wages still weighing on inflation 



Inflation-graph.jpg

Source: ONS
*Average Weekly Earnings Excluding Bonuses 3M/Year on Year


2018 will (barring a Brexit referendum, Trump election, commodity price crash or similar event) be about the subsiding effect from weaker Sterling on inflation and then the numbers will represent the underlying drivers of inflation in the domestic economy.

These underlying drivers paint a picture of the UK economy which will, over the medium term, run near or slightly below the Bank of England’s inflation target. Wage growth has been weak, and even following a recent pickup to 2.1% will not be a driver for significantly higher inflation. Consumers and the market still believe the Bank of England’s inflation target has credibility, and so expectations are fairly well anchored. Fierce online competition and technological change are likely to keep prices in stores under control. Technological development makes current electronics prices cheaper. Commodities seem to be in ample supply given recent investment to supply Chinese demand – which is waning slightly. Combined these factors make for a very benign inflation picture in the UK and globally.

Finally, beyond 2018, the exact nature of the agreement the UK reaches with the EU will be a big driver of inflation. We expect Brexit to be a small medium term negative for the UK economy and so might weigh on inflation. 

Investing involves risk and the value of investments and the income from them may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.