13 January, 2015
If you think that the UK is in a deflationary spiral, then look to Greece to get a sense of what true deflation looks like. UK headline CPI fell to a mere 0.5% annual rate last month, half the rate that it was in November. When prices fall at this pace it is bad news, but the UK could be getting off lightly. In Greece prices are falling at a 2.6% annualised rate as the decline in the oil price combined with a slow economic recovery choke inflation.
Oil slip weighs on CPI
Back to the UK data, anyone who has filled their car with petrol in a UK forecourt will know that falling petrol prices are the main contributor to the drop in the CPI rate. Contributing to this decline was gas and electricity price rises in Dec 2013 which fell out of the calculation for last month. The update from the Office for National Statistics (ONS) who compile this index, was short and sweet, right now there just isn’t strong enough price pressures from elsewhere to neutralise the impact of the decline in the oil price.
Prices unlikely to go anywhere fast
The problem for the Bank of England, whose sole mandate it is to maintain price stability, is that the decline in the oil price is continuing into 2015. Brent crude has already fallen $14 this year and we are only 13 days in. This makes the prospect of CPI falling into negative territory for January a real possibility.
Mark Carney, the Governor of the Bank of England, is the only Bank Governor who has had to write a letter to the Chancellor explaining an inflation undershoot, his predecessor Mervyn King was used to writing letters to the Chancellor but that was because prices were too high.
Champagne and lobster to blame?
Food is another factor weighing on the inflation data. The price of milk has fallen 50% in the last 12 months, and is now cheaper than bottled water. Added to that, news that over half of UK shoppers visited discount retailers Aldi and Lidl over Christmas highlights how supermarket price wars are heating up and starting to have an impact on the data. Possibly for the first time in UK history, cheap lobster and GBP 11 champagne is to blame for the fall in CPI. After the ravages of a 6 year recession, Greek prices are falling for very different reasons.
Core prices, when you strip out food and inflation, actually rose last month to 1.3% from 1.2%. This is still well below the 2% target rate suggesting that the UK is likely to be in a low inflation environment for some time.
The policy impact: no rate rise in 2015?
On the back of this sharp decline in prices the market has pushed out a potential BOE rate hike even further. No rate hikes are expected at all this year, according to the GBP Sonia curve (interbank lending rates). The two year yield, which can move on the back of rate expectations, has also fallen sharply since peaking at 0.93% in July; currently it is lingering at 0.38%. Although wage growth is nearly 1% higher than CPI, it is still only 1.4%, below the BOE’s target 2% CPI rate. Also, when adjusted for core inflation, real wage growth is a measly 0.1% (see chart below). In our view it may take a while longer for the BOE to deem it necessary to hike rates on the back of wage pressures, for now the market could be right in thinking that rates will remain steady this year.
Inflation and the pound: it’s not all about the UK
The pound has been pummelled since peaking in July, and its fall has corresponded with the decline in declining rate expectations. Interestingly, the pound has had a mini bounce post the data, and is managing to cling on above 1.5100, but we continue to think that the bias is lower for GBPUSD. As we have mentioned in recent notes, 1.50 is a key psychological level that could thwart the downside pressure, and below there is 1.4814 – the low from July 2013 – which could also act as a powerful barrier for the bears.
While the technical signals do not show any sign of a change in trend for the pound, from a fundamental perspective, whether or not the pound sees life below 1.50 could depend on US CPI data released this Friday. If the US is also impacted by the global disinflationary trend then we could see the dollar struggle as the market starts to price out the prospect of Q2 rate rise from the Fed.
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