• CPI rose to 0.6% in December, latest data from the ONS show
• Transport, and recreation and culture led the inflation rise
• The price of petrol, clothing and computer games rose in December
• Food prices fell, in particular cooked ham and cauliflowers
• Markets now pricing in a 40% chance of a rate cut this year
Laith Khalaf, financial analyst, AJ Bell
“There’s not much in the way of a pattern to discern in the latest inflation data, which is perhaps not surprising given the huge disruption to consumer behaviour caused by the pandemic.
“The price of computer games rose, with a largely captive audience stuck at home and Christmas no doubt fuelling sales. Clothing prices rose, in a marked difference to usual seasonal trends, reflecting heavy and prolonged discounting during November. The price of cooked ham and cauliflowers fell, and while that combination may not make for the most appetising of meals, there was a reduction in food prices more broadly, which is good news for monthly budgets. Perhaps the more worrying trend was the 1.5p rise in petrol prices over the month, as the oil price has continued to climb, and can be expected to move further upwards if there is an economic recovery this year.
“It’s prudent not to draw too many conclusions from consumer price measures right now, because levels of economic activity are so deeply distorted. While inflation looks well contained, there is increasing concern it could start to be a problem once social restrictions are lifted, as a wave of pent up consumer demand is unleashed. Central bank stimulus, helicopter money from the government, and high levels of cash savings built up during lockdown all support the thesis that the inflation genie may pop out of the bottle in the coming year.
“It’s fair to acknowledge there are also deflationary pressures in the economy. In particular unemployment is set to rise, while technological advances and an ageing population are long term secular trends that continue to weigh down on price rises. A stronger pound also helps in the short term to mitigate rises in imports, most notably for fuel which is priced in dollars. UK interest rate markets certainly aren’t buying the inflationary narrative. They are pricing in a 60% chance of rates staying where there are, and a 40% chance of a cut in the next 12 months. Meanwhile members of the Bank’s rate-setting committee are openly talking about the possibility of negative rates.
“While monetarist economic theory tells us that the huge increase in money supply will deliver inflation, this is a dog that didn’t bark after central banks embarked on the QE experiment in the wake of the financial crisis. Today however, loose monetary policy is combined with fiscal stimulus, and could be turbo charged by the prospect of consumers making up for lost time when social restrictions are eased. So there is some reason to believe this time really is different.
“If inflation does take hold, the Bank of England has plenty of ammunition to throw at the problem by raising interest rates from historic lows. The issue is the Bank won’t want to tighten policy until the economy is able to withstand it. The nightmare scenario for the central bank is stagflation, where inflation becomes rampant, but the economy stalls. This would force the bank to choose between letting inflation spiral out of control and keeping the wheels of the economy turning.
“The Bank isn’t expecting to face this dilemma. Their November forecast suggested CPI would tip only slightly over 2% at the back end of this year, but then remain on target in the longer term. That was based on the assumption interest rates would turn negative in line with market expectations, which suggests the Bank thought there was scope to cut rates without stoking inflation.
“We’ll get a new batch of data and commentary from the Bank of England on 4th February, which will give us fresh insight into their view of the UK economy after the Brexit deal and the imposition of a third national lockdown. However, economic forecasting is a hit and miss business at the best of times and given the extraordinary circumstances we find ourselves in, predictions need to be treated with an extra dose of caution.”
