What Should We Make Of This Latest Inflation Rise?
What should we make of this latest rise in UK inflation? Is it because of Brexit? And are interest rates now set to rise for the first time in almost a decade?
This was a sharp inflation increase. In February, the consumer price index was 2.3pc higher than in the same month in 2016, compared to a 1.8pc annual increase the month before. Less than six months ago, in October 2016, annual CPI inflation was remarkably subdued, at 0.9pc. Now UK inflation has shot above the Bank of England’s 2pc target for the first time since 2013.
Some are describing rising inflation as “another cost of Brexit”. It’s true that the fall in sterling since last summer’s referendum has caused import prices to increase, pushing up the CPI. And with inflation growing marginally faster than average earnings last month, which rose 2.2pc, real wages just fell.
For now, consumer spending remains strong. Retail sales jumped 1.4pc last month, way above most forecasts. And the latest Bank of England survey of 700 British businesses suggests investment intentions have rebounded since the apparent gloom which followed last June’s Brexit vote. But if inflation keeps rising, and real wages are squeezed, that could indeed cause consumers to retrench, slowing the broader economy.
It’s simplistic, though, to “blame soaring inflation on Brexit”, as several commentators have rushed to do. Consider that consumer prices in Germany rose by 2.2pc year-on-year in February, a 4-year high, with inflation only a fraction lower than Britain. I’m not aware Germany has voted to leave the EU. In the US, similarly, inflation hit 2.7pc last month, with American consumer prices rising faster than at any time over the last five years. And the dollar, unlike sterling, is firmly up on a trade-weighted basis.
The main reason inflation is now spiking in the UK and many other large Western economies is, of course, the oil price. Crude spent almost all the first quarter of 2016 below $35 a barrel and has spent much of the same period this year above $55. Once you factor in a 60pc oil price rise, inflation becomes easy to explain. As the fine print of the UK’s February CPI number shows, transport prices – driven by fuel costs, of course – were up a chunky 6.9pc year-on-year. It’s a similar story in the US, Germany and elsewhere.
At the time of our EU vote, UK inflation was as low as 0.5pc. I’d say that roughly two-thirds of the 1.8 percentage point increase since then can be attributed to rising fuel and food prices, with much of the rest due to weaker sterling. Consider, also, that a cheaper pound has sparked an export boom, which, in turn, has boosted wages and broader growth. Car production in the UK just hit a 17-year high, the result of record exports.
Rising inflation, then, is only in part due to the fall we’ve seen in the pound, having more to do with a rather sizeable year-on-year oil price increase. And the impact of that very fall in the pound, so often characterized as “a loss in wealth”, is itself double-edged. For many UK industries, a more competitive exchange rate has been a godsend.
While the cause of inflation is debatable, what’s clear – in my view, at least – is that interest rates need to rise. The Bank of England held rates at 0.25pc earlier this month, but that’s been characterized as a “hawkish hold”, with one of the nine members voting for a increase and “some members” ready to consider a hike if there were “further upside surprises”.
Most mainstream commentators say rates won’t go up until next year, at the earliest. The Bank, we’re told, will “look through” recent CPI rises. I accept that central bankers everywhere are nervous about upending extremely fragile financial markets. For many investors, on-going ultra-low rates, and ever more quantitative easing, are already priced-in. Unsettling those assumptions could cause a sudden, tumultuous, market reaction.
It now seems extremely likely, though, that the Bank’s forecast of a 2.8pc inflation peak in mid-2018 will soon be seriously overshot. The respected National Institute is forecasting a much higher 3.7pc inflation peak. The Old Lady, already behind the curve, risks being caught with napping.
More generally, long-standing negative real rates are penalizing not only ordinary savers but also institutional investors such as pension funds. Low bond yields mean that, to meet on-going obligations, such investors are forced to channel money into far risky financial assets, stoking another boom/bust cycle.
Negative real rates also squeezing banks’ profit margins, making them even less willing to lend. Far from encouraging growth, that slows activity. That’s why not City grandee Sir Martin Jacomb says rock-bottom rates are “causing great harm” to companies and households.
The influential Bank for International Settlements judges that monetary policy is “overburdened”, posing “a potential threat to financial stability”. US investment guru Bill Gross says “central bankers are threatening the engine of the economy by keeping interest rates too low for too long”, concluding “this cannot end well”.
Last week, the US Federal Reserve sought to head off inflation with a third interest rate rise since the 2008 financial crash and the second in three months – taking America’s base rate to 1pc. What’s now desperately needed, as this column has written before, is for the US, Japan, the Eurozone and Britain to get together and agree to a coordinated rate rise – to signal the start of a return to normality.
The Federal Reserve has just marked the turning of the global interest rate cycle. Working with other central banks, and advocating a joint-rise if possible, the UK should now reciprocate.