UK – CPI Inflation Overshoots Yet Again

The CPI rose 1.0% (m-o-m) in December, a record m-o-m gain, lifting the y-o-y rate to 3.7% from 3.3% in November and 3.2% in October. We expected 3.2% (y-o-y) for today’s figure, the consensus was 3.4%. In all, CPI inflation has overshot the pre-release consensus 23 times in the 33 months since April 2008, with just 6 undershoots and 4 in-line readings. Retail price index (RPI) inflation was actually in line with consensus this month (0.7% m-o-m, 4.8% y-o-y), but also has overshot consensus in 23 of the last 33 months. Inflation continues to sharply overshoot the Monetary Policy Committee’s (MPC) forecast. In late 2009, knowing that the 2010 VAT hike lay ahead, the MPC forecast CPI inflation in Q4 2010 to be 1.6-1.7% with only a 13% chance that inflation would exceed 3.0% (y-o-y): the outturn for Q4 2010 was 3.4% (y-o-y).

Our provisional forecast is for CPI inflation to hit 4.0% (y-o-y) in January, subsequently heading above 4½% during 2011. It may even hit 5% (y-o-y) for a month or two, although of course the exact peak will depend on commodity prices and other factors. To be sure, the inflation overshoot partly reflects tax, food and energy prices, plus the pass-through of the currency-driven rise in import prices. CPI excluding indirect taxes is 2.0% (y-o-y). The MPC does not face an immediate crisis of domestic-led inflation. But, in our view, the MPC does face a crisis of inflation forecasting (CPI keeps overshooting their forecasts) and a crisis of credibility (the MPC seems to tolerate repeated inflation overshoots, fuelling suspicions that they may have quietly abandoned the inflation target as too difficult to meet). We expect that rising inflation expectations and some pick-up in pay deals will prompt the MPC to start hiking in Q2 or Q3.

The split shows a particularly sharp rise in food and energy prices in December, with the aggregate inflation rate for food, energy, drink and tobacco (i.e. non-core items) up to 6.4% (y-o-y) in December from 4.9% in November, and this is the highest since 2008. Core inflation (CPI ex food, drink, tobacco and energy) edged up to 2.9% (y-o-y) in December from 2.7%, with particularly strong rises in travel fares. The inflation rate for consumer goods was stable at 1.4% (y-o-y), and hence if there was advance pass-through of the VAT hike then it appears to have been similar to a year earlier (and therefore not a major factor in the upside surprise for the y-o-y rate).

Figure 1: UK – Outturns for Inflation Compared to MPC Forecasts Made Four
Quarters Earlier, 1998-2010

While CPI inflation overshot this month, the RPI in December was capped by a further drop in the housing depreciation element (third consecutive monthly drop), reflecting the recent declines in house prices. There also are other differences between the RPI and CPI. For example, petrol prices rose slightly more on the CPI measure (2.8%) than the RPI because the CPI uses the average petrol price for the whole month whereas the RPI measures petrol prices on a particular day.

Although some are sceptical of the MPC’s motives, we genuinely believe that the MPC are not aiming to inflate away debts (public and private) and nor have they abandoned the inflation target. The inflation overshoots are not a deliberate MPC policy aim. However, the MPC has been willing to err on the side of too much stimulus rather than too little, and also has not allowed enough for inflation pressures from global costs, the lagged effects of the weak pound, loose monetary policy and the drop in capacity during the recession. Global cost pressures are strong, exacerbated by sterling’s sharp drop over the last few years, and in aggregate firms appear to have managed their capital stock aggressively in the recent recession – cutting business investment sharply – and hence have prevented the usual post-recession disinflationary overhang of low capacity use from emerging. Moreover, monetary policy has been very loose, with ultra-low interest rates, substantial QE plus the low pound, hence fuelling a relatively rapid rebound in nominal GDP growth that has allowed firms to pass on costs. The role of monetary policy in contributing to the inflation overshoot was acknowledged by Paul Fisher of the MPC in today’s press interview “The decisions we took through 2009 are the ones that are determining [the] inflation rate now…”.

Figure 2: UK – Inflation Outturns and Citi Forecasts, 1997-2016

In our view, the MPC should not be setting rates to pull this year’s inflation back to the 2% target. It makes sense to look through the one-off effects of tax, food and energy to an extent. However, the MPC’s problem is that the repeated inflation overshoots have eroded confidence in the MPC’s ability to produce tolerably accurate inflation forecasts, but of course such forecasts are needed to set policy appropriately over time. We do expect that inflation will fall in 2012, but we doubt it will head back to target in 2012-13 unless sterling rises sharply, global commodity prices plunge or interest rates rise. In our view, the MPC need to show two things: first, that they take the inflation target seriously, which means tough rhetoric near term and then probably also higher policy rates in coming months. Second, that they are learning lessons from the repeated inflation overshoots and are able and willing to keep inflation close to target over time even if the world is more inflationary than expected and the UK economy has less disinflationary slack their traditional output gap estimates imply.

Figure 3: UK – Rolling 12-Month Total for Gap Between Inflation Outturns and Pre-Release Consensus, 1998-2010