EY ITEM Club special report on inflation

Economic forecast in detail

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Outlook for inflation

Having averaged 3.1% over the past six years, UK retail price inflation, as measured by the headline CPI, is expected to peak above 3% this summer, and average 2.9% for 2013 as a whole. While both external and domestic inflationary pressures will ease slightly in the short term, there is little prospect of inflation getting back down to 2% for the foreseeable future. We expect to see a modest decrease to 2.6% in 2014 and 2015, drifting down to 2.5% in 2016. Meanwhile RPI inflation will stay above the CPI throughout the forecast period, with rising housing costs causing it to accelerate away from CPI in 2015 and 2016.

Impacts on consumer spending

The high retail price inflation seen in recent years has outpaced earnings and eaten into household spending power. Ongoing relatively high inflation will continue to impact consumer spending, especially with unemployment unlikely to fall quickly. The effect on consumer spending will vary between different demographic groups and product sectors, causing companies to revisit their offerings. Meanwhile, average earnings growth will experience a pick-up from 2014, but is likely to take several years to return to more ‘normal’ rates of 4% or more. While this relatively low level of earnings growth would normally help to reduce inflation, domestic inflationary factors will mitigate against this.

Commodity and input factors

The external drivers behind the return of inflation include higher commodity prices, especially food and energy, and rising prices of manufactured goods imported from emerging markets. While these pressures should ease slightly this year, with the recent fall in global oil prices gradually feeding through to petrol prices at the pumps, the outlook for 2014 and beyond is uncertain. For example, the trend of rising prices of imported goods from emerging markets is likely to continue, with China in particular set to see sustained upward pressure on wage growth as the expansion in its domestic labour supply slows down.

Domestic factors

Domestic inflationary drivers include administered and regulated prices, such as domestic energy prices and university tuition fees. While domestic inflationary pressures will ease slightly this year, tuition fees will continue to add 0.4% a year to the CPI until late 2015, compounded by forthcoming rises in rail fares and by higher gas & electricity prices, (as suppliers’ costs are increased by the need to comply with climate change targets).

Implications for monetary policy

Continuing high inflation could limit the Monetary Policy Committee’s (MPC’s) room for manoeuvre on interest rates, while also making it difficult to implement the Chancellor’s proposal for more forward guidance. For example, with inflation still above 2.5%, it would be hard for the MPC to emulate the US Federal Reserve by announcing that it would not increase base rates before unemployment has fallen below 6.5%, with an inflation override of 2.5%. Such a commitment could effectively tie the MPC’s hands, since it would be expected to keep rates on hold until the thresholds were reached, and then raise them at that point.