UK consumer price inflation stable at 0.3% in May

The Office for National Statistics ONS) reported that consumer price inflation was stable at 0.3% in May, after falling back to this level in April from a 15-month high of 0.5% in March. The spike in inflation in March (from 0.3% in February) followed by the dip back to 0.3% in April was primarily due to the earlier Easter in 2016 compared with 2015. In particular, this caused air fares to rise markedly in March in 2016 rather than in April, as had been the case in 2015.

Consumer price inflation has picked up only slightly overall from 0.1% in November and marginal deflation of 0.1% in both October and September 2015. The United Kingdom had also experienced a 0.1% year-on-year (y/y) dip in consumer prices in April 2015, which was the first instance of deflation since the consumer price index (CPI) series started in 1989. Furthermore, the ONS indicated that April 2015 represented the first deflation since 1960, based on comparable historic estimates. In fact, consumer price inflation was locked in a very narrow -0.1 to 0.1% band from February 2015 through to November. This meant that consumer price inflation was 0.0% over 2015, which was down from 1.5% in 2014, 2.6% in 2013, and 4.5% in 2015.

May was the 29th successive month that consumer price inflation had been below the Bank of England's target rate of 2.0%. It also meant that consumer price inflation remained more than one percentage point below the target rate. This has already necessitated Bank of England Governor Mark Carney writing six open letters to Chancellor George Osborne (between February 2015 and May 2016) explaining why consumer price inflation has moved more than one percentage point below its target rate of 2.0% and what the Bank of England proposes to do about it. Carney has to do this every three months that inflation remains more than one percentage point below the target rate).

Higher petrol prices in May countered by lower clothing prices

There was a modest upward impact on inflation in May from higher petrol prices as a result of oil prices reaching 2016 highs during the month. However, the upward impact of this was limited by the fact that oil prices also firmed in May 2015. Other upward factors on inflation in May came from higher restaurant and hotel prices and also from higher communication prices.

However, a downside influence on inflation in May came from air fares falling less during the month than they had in 2015. There were also downward influences from lower prices for food and clothing, as well as for recreation goods (mainly games, toys and hobbies).

Core inflation stable in May

Core consumer price inflation (which excludes food, drink, tobacco, and petroleum) was stable at 1.2% in May after falling back to this level in April from a 17-month high of 1.5% in March. March's peak was up from 1.2% in both February and January. It had been as low as 0.8% in June 2015. The March spike in core inflation was significantly influenced by the higher air fares that month. Indeed, services inflation rose from 2.4% in February to 2.8% in March and then fell back to 2.4% in April. In contrast, the y/y drop in goods prices remained at 1.6% in April and March, having edged up to this level in February from 1.5% in January.

In April, services inflation firmed to 2.6% from 2.5% in March, but this was countered by the y/y fall in goods prices widening to 1.8% from 1.6%.

Very low inflation has helped consumers

Prolonged negligible consumer price inflation has been of major benefit to consumers through supporting their purchasing power. However, some employers are clearly using prolonged negligible inflation as a reason to limit pay awards, which is less good news for consumers.

At 0.3% in May, consumer price inflation is 1.7 percentage point below annual average earnings growth of 2.0% in the three months to March (the usual benchmark used and the latest available data), thereby indicating still decent consumer purchasing power.

However, it is notable that the positive gap between earnings growth and consumer price inflation has essentially halved from the peak level seen in September 2015, thereby diluting consumers' purchasing power even though it is still decent. Specifically, annual average earnings growth was 3.0% in the three months to September 2015, when it was 3.1 percentage points above deflation of 0.1% for that month

Outlook and implications

On the assumption that the UK votes to stay in the European Union in the 23 June referendum (which is increasingly questionable), consumer price inflation should trend gradually upwards over the coming months. Rising inflation should result from the impact of past sharp drops in oil, commodity, and energy prices gradually diminishing, magnified by current firmer oil and commodity prices. Brent oil is currently trading at around USD50/barrel, compared with January's near 12-year low of USD27.10/barrel. This should be reinforced by sterling's overall appreciable retreat from late-2015 peak levels, an expected renewed pickup in earnings growth and eventual elimination of the limited remaining slack in the economy as growth picks up anew in the second half of 2016.

Specifically, consumer price inflation is seen reaching 1.0% in the fourth quarter of 2016 and 2.0% in late-2017. IHS believes that Brent oil prices will likely hover in a USD45–55/barrel range for some time before firming towards USD60/barrel in late 2017. Additionally, commodity prices will probably firm gradually.

Meanwhile, GDP growth is seen as limited to 1.9% in 2016, before strengthening to 2.4% in 2017, which should result in only gently rising core inflation. Earnings growth will probably firm after its late-2015/early-2016 softness amid a tighter labour market and April's introduction of the National Living Wage, but it may well remain limited by some employers using low inflation as a reason to cap pay awards. Furthermore, an expected renewed pickup in productivity (which relapsed markedly in the fourth quarter after earlier improvement in 2015) should limit the inflationary impact of rising earnings.

Retailers, manufacturers, and services companies will likely find their pricing power limited for some time to come, given that the past prolonged squeeze on households' purchasing power has made consumers price conscious. Indeed, supermarkets currently remain heavily engaged in a food price war. Additionally, inflationary pressures are very weak in the United Kingdom's trading partners, which should restrain import prices.

Of course, the consumer price inflation and GDP growth outlook will likely be very different should the United Kingdom vote to leave the European Union in the referendum. There are very good reasons to believe that a vote to leave would result in a sharp fall in sterling with very significant inflationary implications. At the same time though, there is a very real risk of markedly weakened economic activity, particularly as the consequence of heightened uncertainty among businesses and consumers, leading to less investment, higher unemployment, and reduced consumer spending. These developments would have diverse implications for monetary policy.

Bank of England seen most likely to raise interest rates in Q2 2017

On the assumption that the UK votes to stay in the EU, we expect the Bank of England's eventual next move will be to raise interest rates from 0.50% to 0.75% – but not until May 2017.

IHS suspects that the UK economy will strengthen in the second half of the year, helped by reduced uncertainty. Furthermore, we expect consumer price inflation will trend gradually higher during the second half of the year and that there will also be a gradual pickup in earnings growth due to the tightness of the labour market and April's introduction of the National Living Wage

Further out, we see interest rates only edging up to 1.00% at the end of 2017 and to 2.00% at the end of 2018.

Should the United Kingdom vote to leave the European Union, the likely resultant near-term combination of lower growth, higher unemployment, and higher inflation would have conflicting implications for what monetary policy the Bank of England should follow. IHS suspects it would be most likely that the Bank of England's next interest rate move in the event of a vote to leave the EU would be to take interest rates down from 0.50% to 0.25%.