Inflation to move above target as energy prices soar

In our twice-yearly economic outlook, we examine how the government's preferred measure of inflation, the consumer prices index, will overshoot its 2% target as energy and import costs rise - but analysts say the upward drift will be temporary.

With inflation still relatively subdued, and economic growth remaining below par, the May 2006 meeting of the Bank of England's Monetary Policy Committee (MPC) voted by a majority of six to two to keep interest rates at 4.5% for the ninth month in a row. One member voted for an increase, and another voted for a cut. While the continued lack of change in UK base rates has been described as "boring" in some quarters, the minutes of the MPC meeting actually make quite interesting reading¹.

There have been fears in some quarters that sharply rising energy prices would stoke inflationary pressure over the medium term, but the MPC does not appear to share these concerns. On its central projection, the committee judged that the recent sudden upward movement in energy costs will abate, and consumer prices index (CPI) inflation will be close to the 2% benchmark over the medium term.

However, as the minutes of the meeting make clear, there was "significant uncertainty" around this view - some members of the MPC felt inflation would be higher than the central projection, while others felt inflation would come in a little lower.

Against this background, the MPC discussed the arguments for raising rates, cutting rates and leaving them unchanged. Among the arguments for higher rates was the fact that a number of business surveys indicate that the pace of output growth has now risen above trend, and there is still considerable uncertainty about the actual amount of spare capacity in the economy. The arguments in favour of lower rates included the view that spare economic capacity will continue to exert downward pressure on inflation, and that there seemed to be little evidence of any "second-round" impact on wages arising from higher energy costs.

Committee members attached different weight to the above arguments, but most agreed that the risks to the MPC's central projection on both inflation and growth were finely balanced and so, overall, it was felt that there was no need to stimulate demand by cutting rates given the signs of a pick-up in economic activity, and the short-term inflationary risk caused by higher energy costs. Neither was there an obvious need to tighten policy by increasing rates in the absence of any domestically generated inflation.

The comments of various interested parties following the MPC's announcement indicated that there was no unanimity of views on whether or not interest rates should rise, be cut, or remain the same. For example, Ian McCafferty, the CBI's chief economic adviser, said that, while not surprised, the organisation was "slightly disappointed" by the committee's decision. "We believe that inflationary pressures remain under control and, notwithstanding recent news, the economic outlook is sufficiently fragile to permit a small cut in rates," he said.

A different tack was taken by the EEF. It argued that there is no case for a change in base rates - either up or down. "With growth showing no signs of moving above trend and inflation subdued, it is far too early to start talking of increases in rates. The bank must continue to keep its finger off the trigger until there is a stronger case for a move in either direction," said the EEF's chief economist, Steve Radley.

Growth remains subdued

After a period of above-trend economic expansion in 2003 and the first half of 2004, the pace of growth of the UK economy slowed significantly last year in the face of rising oil prices and weakened domestic demand, with gross domestic product (GDP) estimated to have increased by 1.8% in 2005. This, as Oxford Economic Forecasting (OEF) points out, is significantly below the economy's long-term sustainable trend rate - generally thought to be 2.5% a year.

At the time of the 2006 Budget the chancellor, Gordon Brown, forecast that growth will be pitched at between 2% and 2.5% for 2006 (See Budget 2006 - Brown takes another step towards No.10 ). OEF suggests that, while "economic fundamentals are far from weak, neither are they supportive of a strong bounce-back". This being the case, the analyst predicts that GDP will rise by a "relatively modest" 2.2% in 2006. The main driver of this growth will be the service sector, it adds, as manufacturing output is likely to be "stagnant at best", although it is expected to recover towards the end of 2006. The fact that this forecaster expects inflationary pressures to remain subdued, thus allowing monetary policy to "remain accommodative", leads it to conclude that stronger consumer and investment demand will eventually follow. Therefore, GDP growth is expected to return to above-trend levels of 2.7% in 2007 and 3.1% in 2008.

The Royal Bank of Scotland (RBS) expects GDP to rise by 2.3% this year, with a growth rate of 2.6% expected for 2007. Although this forecaster expects business investment to grow marginally faster than GDP, it says there is nothing to suggest that the UK economy is on the cusp of a late-1990s-style investment surge. "The hesitant nature of business investment in recent years has been one of the more surprising (and ultimately disappointing) features of the UK economy, given healthy corporate profitability, and the abundance of affordable capital," RBS says.

Goldman Sachs is more optimistic on growth. It expects demand to accelerate sooner rather than later and, based on evidence gleaned from quarterly business surveys conducted by organisations such as the British Chambers of Commerce, it concludes that GDP will be growing by a healthy 3%, year-on-year, in the second half of 2006. The National Institute of Economic and Social Research (NIESR) also believes that the pace of economic growth is quickening, with expansion predicted to be pitched at 2.5% for this year, and 2.75% in both 2007 and 2008.

CPI inflation to move above target

The latest available figures at the time of writing, issued by National Statistics, show that CPI - the government's preferred measure of inflation - increased by 2% over the year to the end of April 2006, up from 1.8% in March. This means that the CPI is now in line with the Bank of England's target. Over the same period, the all-items retail prices index (RPI) - arguably a more influential yardstick for pay bargainers - increased by 2.6%, up from 2.4% in March.

The consensus is that the recent acceleration in CPI inflation is set to continue, at least over the short term, pushing it above the 2% target, with the upward drift primarily driven by higher energy and import prices. The latest Bank of England Inflation report, published in May 2006, outlines the current thinking of the bank's MPC, the body charged with delivering the Treasury's inflation target². On the committee's central projection, CPI inflation will exceed 2% for the next year or so before gradually easing back towards the government's target as the impact of higher energy costs dissipates.

As we went to press, the latest figures from National Statistics confirmed that CPI inflation has risen above its 2% target, reaching 2.2% in April 2006, its highest level since October 2005. However, this was slightly above the rate expected by the markets, where the consensus was an increase to 2.1%. Among the reactions to the latest news, economists at Lehman Brothers said: "The CPI rate is set to remain slightly above target in next month's (June) data before dropping back to around 2% during the late summer and autumn."

Despite widespread concerns that rising fuel prices could stoke inflationary pressure, there appears little danger of this actually occurring. This has lead one commentator to state that higher domestic inflation is "the dog that didn't bark" - even though petrol price inflation is running at 8.5%; electricity inflation at 17.3%; and gas price inflation at 24.8%. Why is this?

The MPC attempts to provide an answer to this vexing question. It points out that, excluding the most energy-intensive items in the basket of goods and services used to track price movements - utilities, petrol and transport - CPI inflation has been subdued since early 2002, and some way below 2%, helping to mitigate the effect of the more high-profile rises in the cost of fuel. Further, the MPC says that one possible explanation for the weakness of non-energy price inflation relates to the rise in energy prices itself, as higher fuel costs have reduced the income available for spending on other items, displacing the demand for non-energy goods and services and so helping to dampen any upward pressure on prices.

The NIESR's April 2006 forecast notes that inflationary pressure is a little stronger than at the time of its previous forecast, issued in January. "In the past three months, we have seen a notable upward shift in inflation expectations, raising the possibility of a stronger feed-through of [sharp rises in oil and gas prices] to the target measure of inflation," the NIESR says. This led it to predict that the CPI will rise above 2%, and will remain above target for the remainder of this year and for the whole of 2007 before returning back to target in 2008.

OEF's analysts are a little more optimistic, notably in relation to their medium-term projections. While acknowledging that there are upside risks to inflation - primarily, firms are increasingly passing on higher input costs to consumers; further rises in energy costs, and a fall in the value of sterling - it nevertheless concludes that the main risks remain on the downside. There is still no sign of a significant pick-up in consumer demand, it says, and high street competition remains as intense as ever. As a result, the forecaster predicts that CPI inflation will move above 2% in the short term as rises in utility bills continue to feed through, before falling back below target by the end of 2006.

City analyst Goldman Sachs believes CPI inflation will remain "relatively close" to the MPC's 2% target through to the end of 2007. However, higher energy prices are expected to push the CPI above 2%, rising to a peak of 2.5% in the fourth quarter of this year. Thereafter, it is projected to stabilise, and then edge downwards during the course of 2007. Headline RPI will rise throughout the course of this year, reaching 3.1% by the first quarter of 2007, after which time it is forecast to follow the CPI's downward trajectory.

Turning to the all-items RPI - the inflation yardstick still used by most pay setters - the Pay and Benefits Bulletin average as given by our panel of 10 forecasters suggests that headline inflation will be pitched at or around the 2.5% mark for the remainder of 2006 and for the whole of 2007 (see table 1). However, individual analysts differ in their views. For example, the NIESR thinks that headline inflation will be 3.2% for 2006 as a whole, while HSBC Markets predicts it will be almost half this level, at just 2%. There is more of a convergence when it comes to the outlook for 2007 as a whole, with predictions ranging between 2.2% (CBI and Lehman Brothers) and 2.9% (NIESR).

What's happening to labour costs?

Overall, wage growth has remained subdued, with whole-economy average earnings, excluding bonuses, over the three months to April 2006 growing by 3.8%. This compares to a growth rate of 4.1% for the comparable period in 2005. Including bonuses, average earnings increased by 4.4% in the three months to the end of April this year.

In the private sector, in the year to April 2006, pay growth (excluding bonuses) was 3.8%, compared with 3.5% for the public sector. Including bonus payments, private sector growth stood at 4.5%, compared with 3.8% for the public sector.

The May 2006 Bank of England Inflation report comments on what it says is the "muted pace" of earnings growth, and posts a number of potential explanations. The weakening in demand growth in the second half of 2004 and early 2005 may have made companies more reluctant to raise wages. It may also have heightened workers' concerns over their job security and, as a result, made them more wary about pressing for higher wages. In addition, an increased inward flow of migrant labour has helped to ease tightness in the labour market, so restraining upward pressure on earnings. Interestingly, the Bank of England also puts forward another explanation - rising pension contributions.

HSBC Markets agrees that the labour market is not as tight as might have been expected. Even though employment may be rising (due to net immigration and an influx of previously retired workers), the number of people looking for work is rising even faster, it points out. "The result is that the labour market is now loosening faster than at any time since the previous recession. That should keep wage pressure, a crucial input for the service sector, low."

Lehman Brothers, in its UK Weekly Monitor issued at the end of May 2006, considers the current state of play and concludes that the latest National Statistics data sets on earnings are consistent with what it terms "soft wage growth" for the remainder of this year, with a further, gradual, weakening expected in 2007. Although the City analyst says there is a downside risk to its projection from (low) recent pay settlement figures, and continuing concerns about job cuts in certain sectors, it finds no reason to revise its forecast downwards as there is a possibility that the forthcoming increase in the national minimum wage, due to come into effect on 1 October 2006, will have a greater "piggy-back" effect on other wage awards than has been the case in recent years. "Nevertheless, the outlook for unit wage costs, unit labour costs and domestically generated inflation pressures remain benign," it concludes.

The view of the Pay and Benefits Bulletin panel is that whole-economy average earnings for the whole of 2006 will grow by between 3.9% (HSBC Markets and OEF) and 4.7% (Barclays Capital). The range of forecasts for 2007 increases somewhat, and stands between 3.2% (Lehman Brothers) and 4.7% (Barclays Capital).

¹ Minutes of the MPC meeting held on 3 and 4 May 2006, Bank of England, available at www.bankofengland.co.uk , free.

² Inflation report, May 2006, Bank of England, available at www.bankofengland.co.uk , free.

Table 1: Forecast of annual rate of change in retail prices and earnings, 2006/07¹

¹  Based on the latest figures available on 15 June 2006: CBI - March 2006; Goldman Sachs - April 2006; Oxford Economic Forecasting - April 2006; NIESR - April 2006.

²  Pay and Benefits Buletin average: unweighted average of the analysts' predictions.

Source: Individual forecasting organisations.

Table 2: Treasury survey of forecasts¹

¹  Unweighted average and range of around 40 independent forecasts listed in Forecasts for the UK economy, published by HM Treasury, June 2006, tel: 020 7270 4558.

Table 3: Summary of main bargaining statistics