A New Paradigm For Inflation?

On the face of it the last few weeks have provided some positive news for the UK economy. 

Unemployment fell to 5.4%; up from where it was this time last year, but reflecting a downward trend over the last two months.  The healthy labour market does not seem to have yet affected wage inflation, which has fallen from 4.4% in April, to 4.0% in May and has now dropped to 3.5% in June.  This combination of steady-to-falling unemployment, with a labour force that is not yet demanding higher wages, comes amid the backdrop of a respectable rate of economic growth (GDP growth of 3.0%).

Further good news came with the latest inflation figures for the Consumer Price Index (CPI), which is the official method of measuring inflation.  CPI fell to 2.4% in June, down from 2.5% in May and significantly down from the 3.1% figure in April, which forced Bank of England Governor, Mervyn King, to write a letter of explanation to the Chancellor.

All of this should add some cheer to everyone but borrowers who saw UK interest rates rise to 5.75% this month. 

So with CPI coming down and wage inflation seemingly under control, does that mean we can expect an end to the interest rate hikes of the last 12 months?

Well, as you might imagine the story‘s not as cut and dry as the picture painted above.  Inflation remains a significant concern.  The fall in CPI was less than some analysts expected and RPI (Retail Price Index) actually crept up from 4.3% to 4.4% last month – as did the level of ‘core‘ inflation (which excludes food and energy prices).  Further interest rate rises could be fuelled by a rise in the price of a barrel of oil, which is now over $75 for Brent Crude and will add to inflationary pressure; as will the poor summer, which it‘s feared will have a knock-on effect to the price of food as crop yields are expected to be lower this year.

Furthermore, annual UK house price inflation is still in the double digits; the price of a home in Northern Ireland, for example, increased by over 50% last year. 

The next 6 months, therefore, may well be critical in terms of the balance between inflation, interest rates, economic growth and consumer spending.  A key factor will be the degree to which the recent interest rate rises affect consumer spending and hence inflation.  There is always a lag in the correlation between these two factors.

As mentioned above, however, the price of oil could be crucial in determining the medium term tone of the battle between central banks and inflation.  Last Friday the International Energy Agency (IEA) published its monthly report on the supply and demand for energy.  Although the report expected oil production to be higher this year than the previous two (enough to comfortably meet demand), it raised doubt about the ability of future supply to meet demand.  Fewer new oil reserves being discovered, increased geo-political tension (e.g. Nigeria), the lack of investment in refining capacity and an anticipated increase in global demand has prompted the manager of the Investec Global Energy Fund, Tim Guinness, to talk about the possibility of oil reaching $150 a barrel in 5 years time.

If such a situation prompts a greater investment into alternative energy sources, such as bio fuels, there will be an increased pressure on available farmland, leading to rising food price inflation – spurred by rising demand for food from the expanding middle class in economies like China.

All of this represents, if not a new paradigm for inflation, certainly a different one, with the driving forces being commodities and energy, not wages.

[Source: BBC Online, National Statistics Office, IEA, Investec Asset Management, Citywire, Financial Times]