UK Inflation Slide Offers Support to Economy but Could Put the Bank of England in a Bind  

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- UK inflation figures slide beneath BoE target in August.

- Headline CPI drops to 1.7% and core inflation hits 1.5%.

- Clothing, footwear, recreation and culture the biggest drags.

- Lower prices offer support to economy but challenge BoE.

- BoE commitment to raising rates growing difficult to sustain.

The UK inflation rate dropped like a stone in August, official figures from the Office for National Statistics (ONS) revealed Wednesday, which could see consumer prices offer support to a struggling economy in the months ahead but the data also poses a problem for the Bank of England (BoE). 

UK inflation was just 1.7% on an annualised basis in August, down sharply from the 2.1% reported back in July and below the economist consensus that had looked for a reading of 1.8% last month. Core inflation, which is seen by central bankers as a more relevant measure of price pressures because it ignores commodity items like energy as well as alcohol and tobacco, fell from 1.9% in July to just 1.5% last month. 

Lesser price rises for clothing and footwear items exerted one of the biggest drags on the index although recreation and culture goods also weighed on price pressures last month amid another decline in the computer games category. Housing, water, electricity, gas and other fuel costs rose by an unchanged 2.4%, suggesting they played no role in the August decline of inflation. 

"Strong wage growth is still failing to feed through to prices. Recent disruption to Saudi Arabia’s oil production doesn’t look like it will push up inflation much either. Even if the rise in oil prices from $60 to $65 is sustained, it would add just 0.1ppts to inflation at the end of the year. And we suspect Saudi oil output will quickly recover causing oil to return to $60 by year-end," says Andrew Wishart at Capital Economics. "At the margin, this might allow the MPC to strike a more dovish tone at tomorrow’s meeting."

Both headline and core numbers are far below 2% inflation target of the Bank of England, although the BoE had projected an inflation rate of 1.6% for last month and the two measures of price pressures are straddling that forecast.

Above: UK inflation rates and contributions to inflation by category. Source: ONS. 

"The headline rate likely will remain below the 2% target this year....Nonetheless, sterling’s recent depreciation points to core goods inflation rising to about 1.5% in the first half of 2020, from 0.4% in August, boosting the headline rate by 0.3pp. In addition, we expect services firms to respond to the recent surge in unit labour costs," says Samuel Tombs, chief UK economist at Pantheon Macroeconomics and the UK's top rated inflation forecaster. "Accordingly, CPI inflation still looks set to rise back to and then slightly exceed the 2% target in 2020, ensuring that only a sharp downturn in the economy will prompt the MPC to cut Bank Rate again."

Inflation pressures are dissipating at a time when the economy is under pressure from political uncertainty at home and an external slowdown in global growth. Both, taken at first glance, could make the BoE's commitment to an "ongoing tightening" of monetary policy difficult to sustain.

The BoE has said ever since 2017 that inflation is set to test the 2% target repeatedly over the coming years and that a steady increase in interest rates will be necessary to prevent prices running ahead of the target for too long.

However, prices surprised on the downside in August and given the condition of the global economy, might be apt to continue disappointing in the months ahead. Changes in rates are normally only made in relation to the outlook for inflation, which is sensitive to growth and many other things. The BoE is set to announce its latest interest rate decision at 12:00 on Thursday. 

Above: Consensus UK economic forecasts as recorded by HM Treasury.

"The pressure on the MPC to follow other central banks by cutting interest rates has eased substantially over the last month. The newsflow has been positive in the political, financial market and economic spheres," Tombs says. "We look for yet another unanimous vote by the MPC to keep Bank Rate at 0.75% on Thursday, with no new guidance on the near-term outlook. We still think that the next move in interest rates will be up, though most likely not until Q3 2020 and only if a nodeal Brexit is averted."

Growth slowed from 1.8% to 1.4% in 2018 and is on course to slow again this year. Consensus is for the economy to grow 1.2% in 2019, although whether or not it does will depend largely on third and fourth quarter performances. 

The economy shrank by -0.2% in the second quarter of 2019 after having expanded by 0.5% in the opening months of the year, which should have left it up just 0.3% for the calendar year. In other words, the UK needs to see a solid second half to the year if the meagre consensus of 1.2% is to be achieved.

Changes in inventories among manufacturers drove the second-quarter downturn, as companies sold off stocks that were previously built up to protect against possible delays at ports following the original March 29 Brexit day. 

Pantheon's Tombs says similar preparations ahead of the new October 31 deadline should lift growth to 0.4% in the third quarter. Lower inflation, which enables consumers to purchase more items with their money, could also aid growth in the months ahead but if Tombs is right about a third-quarter pickup in stockpiling then it could mean the final three months of the year then see another run-off of manufacturing inventories drag GDP growth lower again. 

"While some softer economic indicators continue to give cause for concern (for example, UK PMIs continue to hover barely above the pivotal 50.0 level (Figure 3)) the labour market continues to be a source of optimism, with headline average earnings now growing at their fastest rate since May 2008. Brexit will determine next steps for policy, but only when the outcome is clear," says John Wraith, an economist at UBS. 

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