Costs and prices

4.1 Recent developments and the near-term outlook

CPI inflation was 2.0% in June, in line with the forecast in May (Chart 4.1). Inflation has been close to the target for the past few months after declining through much of last year as the boost from sterling’s earlier depreciation faded.

Inflation is expected to fall below the 2% target in the near term largely due to a weaker contribution from energy prices (Section 4.2). Petrol prices are expected to decline, so the contribution of fuels and lubricants to CPI inflation turns negative. Similarly, retail gas and electricity prices are expected to fall in Q4 as recent falls in wholesale prices lead to a reduction in the Ofgem energy price cap. Core inflation, which excludes the effects of energy and other volatile components such as food, was 1.8% in June, and is expected to be at similar rates over much of the next six months (Chart 4.2).

Core services price inflation has increased slightly in recent months, in part because unusually weak contributions from car insurance and rents are beginning to fade. This gradual pickup is expected to continue over the forecast as domestic inflationary pressures build (Section 4.3). Those pressures push CPI inflation slightly above the target in the medium term (Section 5).

Developments in inflation expectations, which can influence wage and price-setting decisions, have been mixed but remain consistent with inflation being around the target in the medium term (Section 4.4).

4.2 External cost pressures

Energy prices

Wholesale oil and gas prices have fallen since the May Report (Chart 4.3). Sterling oil prices are around 6% lower than they were three months ago, and around 9% lower than a year ago.

The fall in the dollar oil price has been even larger, but this has been partially offset by sterling’s depreciation.

Oil prices affect inflation directly through their impact on fuel prices. Petrol and diesel pump prices were a little elevated relative to the sterling oil price in June. This appears to reflect unusually high margins in the retail sector. These have tended not to persist in the past, so both lower wholesale costs and a normalisation of margins are expected to push down fuel prices over the coming months.

Wholesale gas prices — which feed through into retail energy prices with a lag — have fallen by 14% since the May Report (Chart 4.3). Wholesale electricity prices have fallen by 2%. These wholesale prices are an important part of retail energy companies’ costs and are used by Ofgem to calculate the energy price cap that affects some common tariffs. Given the recent fall in wholesale costs, the cap — which is reviewed twice a year — is projected to fall in October. Retail gas and electricity prices are consequently projected to drag on CPI inflation in Q4, causing the total contribution of energy to inflation to swing from 0.4 percentage points in Q2 to -0.2 percentage points in Q4 (Chart 4.2).

The MPC’s August projections assume that oil, gas and electricity prices will remain flat after two quarters such that they make a neutral contribution to inflation in the later part of the projections. That is a change from previous forecasts in which they were assumed to follow the futures curves. The reasons for this change are outlined in Box 5.

Non-energy import prices

Import price inflation has been relatively subdued over the past year (Chart 4.4), following high rates over 2016 and 2017 after sterling’s referendum-related depreciation.

The past increase in import prices associated with the 2016 depreciation appears to have largely been passed through to consumer prices. The inflation rate of import-intensive CPI components — those which are imported or have a higher share of imported inputs — has fallen back from its 2017 peak (Chart 4.5). The impact of higher import prices on CPI inflation appears to have faded somewhat faster than had been expected previously. As discussed in a box in the November 2015 Report, the effect of imported price pressures on consumer prices varies over time and will depend on the factors driving the change in the exchange rate.

Sterling has depreciated by around 4% since the May Report (Section 1), which will lead to higher import prices in the future. The outlook for inflation will continue to be sensitive to movements in the exchange rate, which in turn will remain sensitive to Brexit developments. Box 6 in Section 5 sets out how the MPC’s projections for growth and inflation might be different under alternative paths for the exchange rate and other asset prices.

4.3 Domestic cost pressures

The growth of labour costs — which are an important part of many companies’ overall costs — has picked up (Section 3). The extent to which the cost of labour affects companies’ production costs per unit of output depends on how it is growing relative to productivity. Those unit labour costs have grown slightly faster in recent years as wage growth has strengthened and productivity growth has weakened (Chart 4.6).

Unit labour cost measures can be used as indicators of domestically generated inflation (DGI). The recent pickup in labour cost growth means that these measures are now towards the top end of ranges estimated to be consistent with CPI inflation at the target.

Some price-based measures of DGI have been more stable, and remain below or towards the bottom end of their target-consistent ranges. Core services inflation focuses on a subset of the CPI basket that is largely domestically produced, as well as excluding some volatile components such as airfares. This measure has risen a little in recent months, but remains low by historical standards. It has been depressed recently by particular weakness in a small number of components, notably car insurance and rents (Chart 4.7). The unusual weakness in insurance price inflation has begun to ease and is expected to dissipate in the next few months. The weakness in rents inflation is likely to persist for a little longer; although private sector rents inflation has begun to pick up, most social housing rents cannot be increased until April 2020.

The rate of core services price inflation that is consistent with overall inflation at the target is uncertain. Before the crisis, goods prices fell on average (Chart 4.7). This meant that the target-consistent rate of services price inflation was substantially above 2%. Although goods prices are likely to continue to get cheaper relative to services, the pace of relative decline is likely to be lower than pre-crisis for several reasons. First, the prices of imported goods fell in the pre-crisis period as several large emerging economies integrated into global supply chains. This is not expected to be repeated, so import prices are expected to rise in the future. Second, productivity in industries which produce goods increased much faster than in the service sector in the pre-crisis period, but this differential has been much smaller recently. Third, the measurement of clothing price inflation has changed — bringing it more in line with standard practice — such that it is likely to be higher now than before the crisis. Altogether, this means that the rate of services price inflation consistent with the target is likely to be lower than pre-crisis. However, it is hard to know precisely how much lower it will need to be.

Several other price-based measures of DGI have picked up since 2015, although trends over the past year have been varied. The median inflation rate of the CPI’s services items — a measure of services price inflation less affected by volatility in individual items — suggests that DGI has increased gradually since 2015 (the blue line in Chart 4.8). A measure of inflation using only labour-intensive services suggests DGI picked up more sharply after 2015, but has fallen slightly over the past two years (the red line in Chart 4.8). Measures based on prices which have been relatively responsive to wage growth or the output gap in the past have also picked up in recent years, but have been fairly stable lately.¹

Although these measures are all constructed differently, ultimately all of them put a lot of weight on price inflation in different parts of the services sector. However, there are reasons why goods prices may also be informative about domestic inflationary pressures. Goods prices adjust more frequently than services prices, with 24% of goods prices changing every month compared with only 9% of services prices.² Although this probably reflects a need to adjust more frequently to external cost pressures, it may also reveal domestic inflationary pressures at an earlier stage if the influence of external factors can be identified and removed.

In the MPC’s central projection, domestic inflationary pressures are projected to build gradually over the latter part of the forecast period (Section 5). This is expected to be accompanied by stronger growth in the various price-based indicators of DGI.

4.4 Inflation expectations

Domestic wage and price-setting behaviour can be affected by people’s expectations about the likely future rate of inflation. If companies expect average prices to rise more quickly, they may increase their own prices by more, for example.

The MPC monitors a range of indicators of inflation expectations — derived from financial market prices and surveys of households and companies — to assess whether they remain consistent with the 2% target.

Measures of inflation expectations derived from financial market indicators increased over 2018 H2 and have remained above their historical averages in 2019 (Table 4.B). This is in contrast to similar measures in the US and euro area, which have fallen (Section 1).

The increases in shorter-term financial market measures may reflect expectations about the economic impact of Brexit. Some Brexit outcomes could involve tariffs and a sterling depreciation and hence higher import prices. All else equal, these would push up inflation over the next few years.

There may also be market-specific factors affecting these measures. Financial market expectations are for RPI inflation, so can be affected by changes in the expectation for the wedge between RPI and CPI inflation. In addition, the UK’s Debt Management Office has issued fewer index-linked gilts since the start of 2019 than in previous years. This reduction in supply may be pushing up the price of index-linked securities, boosting implied inflation expectations.

Developments in the inflation expectations of households and firms have been mixed, but they are generally closer to their post-crisis averages.

The latest Bank/TNS survey of households suggested that expectations for inflation in one and two years’ time were broadly stable in 2019 Q2, and close to their average levels since 2010 (Table 4.B). Expectations for inflation in five years’ time picked up to the highest level since the survey began in 2009. But there was no material increase in either the YouGov/Citigroup or the Barclays Basix surveys at that horizon. Inflation expectations across the various surveys remain higher than the 2% CPI inflation target on average, possibly as a result of respondents referring to a different price index such as the RPI. Differences in spending patterns and cognitive biases may also contribute.³

Inflation expectations among companies have fallen slightly, with respondents to the CBI Distributive Trades Survey expecting below-average inflation over the next year. The inflation expectations of professional forecasters rose slightly in Q3, and are in line with the 2% target (Box 7).

Overall, the MPC judges that inflation expectations remain anchored. The MPC will continue to monitor measures of expectations closely.

• Notes

  1. For example, see Figure 8 in Saunders, M (2019), ‘The economic outlook’.

  2. For more details, see Bunn, P and Ellis, C (2011), ‘How do individual UK consumer prices behave?’, Bank of England Working Paper No. 438.

  3. For more details, see Tenreyro, S (2019), ‘Understanding inflation: expectations and reality’.