AXA IM's David Page - UK reaction: CPI inflation dips to 3.0%, further declines likely to be small in coming months

David Page, Senior Economist at AXA Investment Managers (AXA IM) comments on UK consumer price index (CPI) inflation.

Key points:

• UK CPI inflation retreated to 3.0% in December from 3.1% with falling transport costs a key feature.
• RPI inflation rose above our expectation to 4.1% from 3.9% to record its highest rate in six years, in part reflecting last year’s increase in Bank Rate.
• Producer prices showed a more mixed performance, input price inflation falling, but output price inflation rising. The latter points to only gradual declines in consumer price inflation over the coming months.
• We forecast CPI inflation remaining around 2.9% in Q1 and 2.7% in Q2 before falling more in H2 2018. We forecast inflation closing the year around 2.25%.
• Modestly faster than BoE expectations, we think this is consistent with our expectation for another 0.25% rate hike in August, ahead of consensus expectations for Q4.  

UK CPI inflation eased back in December to 3.0% from 3.1% the previous month. This was in line with our own and market expectations. ‘Core’ CPI inflation dropped to 2.5% from 2.7%, modestly below expectation (2.6%). Headline inflation fell on a significantly smaller rise in transport services costs, with non-air and rail transport prices falling 3.2% on the month compared with a 4.5% gain last December. Despite petrol and diesel costs rising this year, transport costs rose overall by a softer 2.2%, compared with 2.9% last time around, alone accounting for a 0.1% point fall in headline inflation. Elsewhere, weaker than expected communication and recreational prices were offset by modestly higher furniture prices and a more marked increase in alcohol and tobacco prices.   

Retail price index (RPI) inflation rose to 4.1% in December from 3.9% last month (AXA IM 4.0%, consensus 3.9%). This is the highest recorded RPI inflation in six years (since Dec 2011). The rise in RPI inflation, despite the modest softening in CPI inflation, reflected changes in the difference between the two measures. Part of this (about one-third) reflected the impact of the Bank of England’s (BoE) 0.25% Bank rate hike in November, which fed through to mortgage payments (included in RPI, but not CPI measures of inflation) in December. However, the remainder of this move was more technical reflecting the impact of different products having different weights in the baskets of the two measures of inflation. The difference between RPI and CPI has risen to 1.14% points - its largest in 14-months. We expect this difference to narrow over the coming quarters towards 1.00%, primarily reflecting some normalisation of the ‘weight’ component of the difference.

Producer price index (PPI) inflation for December was also released. Producer input prices retreated more than expected to 4.9% in December from 7.3% in the previous month (consensus 5.3%) – the joint slowest pace of input price increases since the Brexit referendum in mid-2016. It in turn primarily reflects the stabilisation and recent firming in sterling since the sharp declines on 2016. However, producer output price inflation rose in headline and ‘core’ terms to 3.3% from an upward revised 3.1% (from 3.0%) and 2.5% from an upward revised 2.3% (from 2.2%) respectively. Insofar as factory gate inflation tends to be a good forward guide to consumer price inflation, today’s figures are a reminder that CPI inflation is not likely to decline quickly over the coming months, even if CPI inflation has most likely peaked at 3.1% in November and should gradually fall in the months ahead.

We forecast a gradual deceleration in CPI inflation with rising energy prices likely to deter a faster drop. We forecast, CPI inflation to average 2.9% in Q1, only modestly below the Q4 3.0% average and firmer than the BoE forecast in November. We expect inflation to head lower in Q2, but remain above 2.5% until H2 2018. We forecast CPI inflation closing the year around 2.25%. Insofar as our forecasts are modestly higher than the BoE forecasts in the short-term, we expect the Monetary Policy Committee (MPC) to remain cautious over the above-target inflation. However, we believe that future policy changes will be governed more in terms of the outlook for inflation than current inflation. In this context, we believe labour market developments and particularly the tightness of the labour market and any acceleration in wage growth will determine future policy changes. As such we maintain our outlook that the BoE will tighten monetary policy again only in August after data relating to the key January-April wage negotiating round becomes available. This is modestly ahead of consensus expectations, where the latest Bloomberg survey recorded consensus looking for a Q4 Bank Rate hike.   

Financial markets reacted to the dip in inflation, despite it if anything being firmer than expected. 2-year and 10-year gilt yields fell by 2bps to 0.57% and 1.29% respectively. Sterling also fell back by nearly 0.2% against both the US dollar and euro, a move that appeared to buoy equities, which posted a 0.2% rise on the release. Financial markets now price a greater than 50% chance of another BoE rate hike by August 2018, in line with our view.