UK inflation has peaked and is now on a downward trajectory, market commentators have said, as today’s figures from the Office for National Statistics (ONS) show the Consumer Price Index (CPI) dropped from a five-year high of 3.1% in November to 3% in December.
The slight decline, the first drop since June 2017, was in line with expectations and partly a result of a weaker increase in air fares compared to the same month in 2016.
In addition, higher import costs because of the collapse in the value of the pound, which has been largely responsible for driving living costs up in 2017, has fallen out of the figures.
Sterling has been steadily climbing since the start of the year and was today trading at $1.38, the highest level since the Brexit vote.
CPI remains above the Monetary Policy Committee’s (MPC) forecast of 2.7%, decreasing the likelihood of the Bank of England raising interest rates in the near term. Commentators also predicted inflation will fall back to the BoE’s target over the course of the year.
Viktor Nossek, director of research at WisdomTree in Europe, said: “As expected, CPI inflation has fallen back from its multi-year high to end 2017 at 3%. We have long expected the rise late last year to be capped around this level because of a lack of underlying wage inflation in the UK, and indeed inflation should now begin to slide back towards the Bank of England’s 2% target.”
Oil prices
Nossek warned the rising oil price could prove to be the main sticking point, posing the risk of stagflation. Last week, the price of oil rose to $70 a barrel, its highest level since December 2014.
The outlier to this scenario will be the oil price. The sharp rally in oil sparked by OPEC and others restricting supply could yet push up prices at the pump and feed through to UK consumers, he said.
Such a scenario could represent a real challenge to UK consumers, as with real GDP growth somewhat muted and no wage hike pressures, the Bank could look through rising commodity prices as short-term, creating the risk of stagflation for savers and investors.
Thomas Wells, manager of the Smith & Williamson Global Inflation-Linked Bond fund, highlighted the significance of the pound’s gains in countering soaring oil prices.
He said: In terms of the UK’s inflation outlook from here, the recent strengthening of the pound versus the dollar will help to mitigate inflationary pressure to some extent and should help to mean that, over 2018 as a whole, inflation will slowly begin to move back towards the Bank’s target. The recent rally in the pound is particularly important given the current strength in oil prices following production cuts.
UK economy
Ben Brettell, senior economist at Hargreaves Lansdown, said apart from the “Brexit noise”, the UK’s economic situation is in keeping with the majority of the developed world, with an ageing demographic and disruptive technologies causing price pressure and limiting the BoE’s incentive to hike rates.
“I see no reason why UK inflation will not gradually return to the very low levels which persist among our developed world peers,” Brettell said.
All this has implications for interest rates. Given the continued headwind posed by Brexit uncertainty, I do not see why the BoE would rush to raise rates again this year. I see last year’s quarter point move as more of a tacit admission that the cut to 0.25% was unnecessary in the first place, rather than the start of a sustained upwards trend. I would be somewhat surprised if rates were higher than 0.75% by the end of the year.
Wells warns falling inflation could still be derailed by UK politics: While the overall profile for UK inflation looks better for 2018 than it did for 2017, there are some material tail risks that could result in sterling weakness, which would very easily re-ignite inflation concerns; for example, the market is not pricing in a general election this year despite the weakness of the Theresa May government, and there is no guarantee the recent more positive tone of the Brexit negotiations will continue, he said.
AJ Bell investment director Russ Mould said his biggest concern is unexpected wage growth, which would both hit returns in the bond market and prove detrimental to the stockmarkets.
“If there is to be a market shock in 2018, wage inflation could still be its source so bond investors cannot rest easy yet,” he said.
Any acceleration in wage growth would keep the Bank of England on a state of alert, even if the markets seem to expect no more than one interest rate hike in 2018 from governor Mark Carney, from 0.5% to 0.75%.
If wages, broader prices and interest rates rise, that is a bad recipe for bonds, where lowly yields and coupons could be offset by both inflation and any capital losses suffered – since bond prices fall as interest rates go up and the yields on offer are unlikely to compensate for any capital losses that would accrue if interest rates were to rise more rapidly than expected.
Mould added that bond ETF holders may then be unable to sell their holdings at a reasonable price.
Hefty losses here could even knock a hole in global liquidity flows, dampen investor sentiment and choke off appetite for the corporate debt which has been used to fund the share buybacks and takeovers, which have helped to support stock markets.