United Kingdom – Falling inflation keeps hopes of recovery alive

Consumer Price Index (CPI) figures, which were released by the UK Office for National Statistics (ONS) on 20th March, indicate that UK inflation is continuing to head lower, hitting a 15-month low of 3.4% y-o-y in February from 3.6% y-o-y the month before. This reflects a considerable moderation in inflationary pressures since the headline figure peaked at 5.2% in September 2011. 



UK Inflation
Source: Bloomberg

As a highly globalised market dependent on imports, the UK is far more vulnerable to increases in commodity prices than other developed markets. However, core inflation – which strips out volatile components from the consumer basket such as food and energy – fell to 2.4% in February, the lowest figure since November 2009. According to the Office for National Statistics, the fall in inflation was due not only to falling energy costs, but also recreation, culture and transport costs, clearly indicating that underlying domestic pressures are declining.

Part of the current stabilising of prices is due to the impact of the VAT increase tailoring off after it was increased significantly from 17.5% to 20% in January 2011. Although the ONS declared on 28th March that the effect of new taxes and VAT hikes announced in the budget on 21st March on will add 0.17% to the CPI y-o-y rate, we don’t consider this is to be significant enough to deter the current disinflationary trend and believe the Bank of England is still on course to meet its target inflation rate of 2% by the end of 2012.



CPI inflation projections based on market interest rate expectations and £325 billion asset purchases
Source: Bank of England

The Bank of England’s Monetary Policy Committee previously expressed expectations for inflation to fall rapidly in 2012, helping the fragile economic recovery to gather momentum. Although February’s data was just short of the expectations of 3.3%, the steady fall will maintain hopes of supporting consumer spending and alleviating the pressure on households in the short term. This positive outlook for the UK economy reinforces many GDP growth forecasts in 2012, signalling that the UK will avoid another recession. As such, I would not expect the Bank of England to add further quantitative easing once the current asset purchasing programme ends in May.

Risks
With current prices sticking around the US$124bbl mark, the immediate upward risk on price pressures from rising oil prices is still considerable. However, in line with some forecasts for Brent crude to average US$115bbl in 2012, oil prices to fall in the second half of the year as the risk of Iran closing the Straight of Hormuz is priced out of the markets. In addition, should prices spike above the US$127bbl highs of 2011, the International Energy Agency will use its capacity to release its stock piles to calm prices. Indeed, in recent days there has already been talk of the UK, US and French governments releasing emergency oil stocks to ease pressures.
 

Crude Oil Prices
Source: Bloomberg