UK Inflation: Is this ‘Escape Velocity’ and Should the Bank of England be Worried?

The British pound’s outlook ultimately rests with two factors, in our view: The EU referendum in June and UK inflation data.

The referendum is of course the sexier of the two drivers, but it could be the speed of price rises confronting shoppers that truly becomes the market’s biggest concern.

It has been reported on Tuesday the 12th April that the Consumer Prices Index (CPI) rose by 0.5% in the year to March 2016, compared with a 0.3% rise in the year to February. This is ahead of forecasts for a reading of 0.4% to be produced.

The rate has increased gradually since October 2015 although is still relatively low in the historical context.

Inflation matters as it is arguably the single most important variable under the Bank of England’s control.

Since 1998 the Bank has been mandated to target inflation around 2% over the long-term.

One way of boosting the comatose inflation data of recent months is to cut interest rates and expand quantitative easing. To slow inflation that appears to be heading for 'escape velocity' the Bank would need to raise rates.

A side-effect of rising interest rates is a higher pound as the improved yield attracts vast flows of investor money which is always on the hunt for better returns.

Thus, signs that UK inflation is heading back to target is a positive for sterling as markets bid the currency up on anticipation of rates rising earlier than previously thought.

Hence the GBP/USD’s 0.5% rally in the wake of the data.

Indeed, like a speeding train, the brakes must be applied well before the destination is reached.

The Outlook: Oil Prices are Rising, and Could Catch Many by Surprise

So the big issue for sterling is how the Bank of England plays the tricky game of anticipating inflation.

The key variable to consider are oil prices; record low prices of crude have pushed down prices at the pumps which in turn bring down prices right across the supply and manufacturing chain.

The period of low oil prices does however appear to be over, futures markets have been demonstrating a firm belief that the oil markets will continue to see a positive progression in the oil price (up to ~$56/bbl in March 2023).

A fact which has been supported further by the continued gains in the spot price (~$42/bbl) this week.

“Net/net, we do not see the oil price remaining at these levels over the longer term as the impact for forward production attrition makes greater impact on production. We believe that $75 – 80/bbl is the real mid cycle price, and that unless the investment in upstream starts in the next 2 years, that we will see the super-cycle return in the shape of ~$150/bbl oil prices,” warn industry specialists at brokerage and research house SP Angel in London.

Analyst Views: This is not Escape Velocity, 0.5% Growth is as Good as it Gets

Rises in air fares and clothing prices were the main contributors to the increase in the rate between February and March 2016.

These upward pressures were partially offset by a fall in food prices and a smaller
rise in petrol prices than a year ago.

“The Easter travel rush in March will have stung many through costly air fares and higher prices at the pumps, but the fact that inflation is still stubbornly weak will give Osborne and Co. food for thought. Those observers hoping for an interest rate rise soon may be kept waiting a bit longer,” says Dennis de Jong, Managing Director at UFX.com.

Scott Bowman, UK Economist at Capital Economics agrees saying this is as good as it gets:

“Inflation should be fairly flat over the next few months. Core inflation will probably be contained as earlier rises in sterling and falls in oil prices continue to work their way through the supply chain.

“And while petrol prices have been rising again recently, they also increased in mid-2015, which should keep the contribution from fuel prices to inflation steady in coming months. Indeed, we expect CPI inflation to average around ½% this year.”

Economists at Lloyds Bank believe any further gains will be incremental:

“Overall, today’s outturns do little to change our view that the climb in annual inflation towards 1% by the turn of the year is still likely to prove hesitant.

“To be sure, the recovery in oil prices continuing alongside the ongoing weakening of sterling is likely to provide incremental impetus. However, the pickup this month likely overstates these impacts. With measures of underlying unit costs softening in the latest data for Q4 – despite the backdrop of a tightening labour market – the gradient of the inflation uptrend is still likely to remain shallow.”

I don’t know about you, but I have a feeling these guys could be proven wrong, based on developments in the oil market.

Higher oil prices will feed into prices at the pump and household gas bills more rapidly than falling prices do; this is always the case.

Then there are forecasts for a notably weaker sterling which will make the cost of importing energy all the more expensive.

While next month will probably deliver similar results I believe towards mid-year we could see some uncomfortable rises.