The threat of sustained above-target inflation has passed. The Bank of England is likely to say in next week’s Inflation Report that it expects CPI inflation to fall next year to below its 2 per cent target.
There are two fundamental reasons for this.
One is that wage inflation has fallen, from 2.8 per cent in November to just 1.8 per cent in the latest numbers. This is a big surprise: most economists had expected higher price inflation and lower unemployment to raise wage growth. This means there is now little danger of a wage-price spiral.
The other is that global inflation is low. Commodity prices have fallen by 8 per cent since January. Thanks to this, UK producer input prices have dropped almost 2 per cent since then.
These disinflationary forces should mean that CPI inflation will fall soon simply because rises in import prices caused by last year’s fall in the pound will drop out of the annual data. It now looks as if those rises will cause only a one-off jump in the level of consumer prices, rather than sustained inflation.
This doesn’t, however, mean inflation will slump. One problem is that labour productivity is stagnant. If this continues, it means that even modest wage rises won’t be offset by efficiency gains. Two per cent wage growth would then mean a 2 per cent rise in unit wage costs, which in turn would mean 2 per cent inflation unless raw materials or import prices fall or unless profit margins get squeezed.
Also, a recent Bank of England survey found that households plan to continue to increase their nominal spending next year. This is an environment in which retailers might try to edge up prices.
Nor does it mean that interest rates won’t rise. There’s a case for trying to return rates to a more normal level – or at least to remove last year’s insurance cut. Unless growth is very weak, some MPC members will continue to make this case.
It’s also possible that the chancellor will interpret the general election result as a vote against austerity and so use the Autumn Statement to relax fiscal policy. Less tight fiscal policy should lead to less loose monetary policy.
There is, though, a big and under-appreciated uncertainty here. It’s that the dominant traditional theory of what causes inflation is now in question. Economists used to think inflation depended in large part upon the amount of spare capacity in the economy. The fact that wage inflation has fallen, despite low unemployment, brings this into question. Back in November, the Bank estimated that the “unemployment rate is currently close to its medium-term equilibrium rate — that consistent with neither upward nor downward pressure on wage growth.” But wage growth has since fallen by a percentage point.
This might not be due simply to difficulties in measuring 'equilibrium' unemployment but rather to a changed relationship between spare capacity and inflation.
This introduces a new element of uncertainty. Not only do we have ordinary environmental uncertainty – about the likely influences upon inflation such as sterling, consumer spending. productivity and so on – but we also have model uncertainty: what is it, precisely, that determines inflation?
Our best guess might be that inflation will fall towards its target. But there are risks around this.
