Inflation is one of the key current domestic issues the UK economy faces. And in turn it drives monetary policy and has a major influence on the outlook for financial markets. Since the Referendum result last June, the UK economy has performed very much as we had expected - even though at the time our view differed from the consensus. As expected, sterling fell, the Bank of England cut rates, growth held-up, jobs increased and inflation rose.
Wage rises are subdued but inflation has picked up again
This week's official data has provided further evidence of low unemployment and solid jobs growth, but also still subdued wage rises at a time when inflation has picked up again. As a result, real wages are being squeezed, which is expected to weigh on consumer spending growth in coming months. But this has not happened yet, as this week's data also showed, with retail sales growth rising strongly in April. This follows recent evidence of healthy auto sales, admittedly driven by credit, and also a strong distributive trades survey from the Confederation of British Industry. All of this suggests that consumer spending has started the second quarter on a strong footing.
Could Bank of England inflation forecasts be too low?
It was only last week that the Bank of England's quarterly inflation report signalled its latest thinking. In its previous report three months ago the Bank expected wages to rise 2.9% in the first quarter of this year. In the event they were up 2.3%. In its current report, the Bank predicts inflation will peak at 2.8% in Q4, and then subside. But one wonders whether this peak may already look too low, as data this week showed annual Consumer Price Inflation reaching 2.7% in April, versus 2.3% in March.
Inflation has risen globally since last summer. This aspect is often ignored in the UK, where the rise in inflation is often attributed solely to Brexit. Higher global inflation reflects the shift towards reflation, which is boosting global growth and inflation.
How higher inflation could help trim the deficit
One important positive aspect of this is often overlooked. Higher nominal GDP (which is economic growth plus inflation) alongside still low long-term interest rates can have a very positive impact on debt dynamics. Often when inflation rises - whether in the UK or elsewhere - both short-term rates and long-term yields rise, often sharply. But when this doesn't happen and nominal GDP genuinely picks up, then the impact can provide a pleasant surprise to Government finances.
In recent years, austerity has not worked that well - although the UK budget deficit has fallen in relation to GDP - and there is a sense of a long slog ahead to get the deficit back into surplus. But, solid nominal GDP growth might help cut the budget deficit quicker. Obviously, much depends on what happens next, not just to growth but also to inflation, interest rates and market expectations.
Could the Bank of England change direction?
The Bank of England's thinking is that the rise in inflation will be sharp but temporary, peaking later this year, before trending lower next year. As a result, its message has been that it will not tighten policy. However, the latest minutes from its Monetary Policy Committee meeting indicate that if there are any inflation surprises on the upside in coming months, it would need to reconsider.
On that basis it might. In which case, in coming months the debate about interest rates will return to the fore. Of course, as the economy stays firm, or even as the markets speculate whether the Bank will raise rates, sterling benefits and that in itself takes some of the pressure off the need for interest rates to rise.
Higher global inflation and the weaker pound have pushed import prices up. In turn, this has fed sharply higher input prices and led to higher factory gate prices. The sharp rise in inflation may not peak until later this year, or early next, and also depends on many factors.
Profit margins are relatively healthy and may be squeezed as firms keep prices down to maintain market share. This is what happened the last time we had a similar situation in the aftermath of the financial crisis, when sterling had also fallen sharply. Then the rise in inflation was sharp, but temporary.
Inflation should peak at the end of 2017
Another key influence will be what happens to domestic cost pressures. Here the focus is on domestically-generated inflation and this includes services, domestically-produced output and labour costs. If these start to trend higher, than the fear will be that the current inflation rise will be more than temporary. The strong labour market could yet see wages rise more firmly. Our view has been that inflation will peak at the end of this year, possibly at the start of next, possibly nearer 3.5% before it trends lower next year. We retain our 2% economic growth forecast for this year.
So far, for the authorities, the focus is on whether the rise in inflation is solely driven by imported cost pressures, as it largely has been, or whether it triggers higher domestic cost pressures. UK markets could be impacted by a more intense debate over monetary policy this summer, and as inflation heads higher. That debate is needed, and will likely be given further fuel by the outline of fiscal policy post the election.