Costs and prices

4.1 Consumer price developments

CPI inflation was 2.1% in December 2018, having fallen from 3.1% in November 2017, partly due to the diminishing effects of the referendum-related sterling depreciation. Inflation in 2018 Q4 as a whole was 2.3%, lower than forecast in the November Report. That was partly because petrol prices were lower than expected, reflecting the significant fall in oil prices since November. Food price inflation and clothing and footwear price inflation were also slightly lower than expected.

Inflation is expected to fall to 1.8% in January, and to remain just below the target throughout 2019 Q1 (Chart 4.1). That forecast is lower than in the November Report, mainly reflecting the continued impact of lower petrol prices. It also includes the estimated impact of measures announced in Budget 2018. These measures include a freeze in the rate of fuel duty and some alcohol duties, which together reduce inflation by just under 0.1 percentage points from early 2019.

Over the forecast period as a whole, external cost pressures are expected to be lower compared with recent years (Section 4.2). Domestic cost pressures are expected to continue to strengthen (Section 4.3). Inflation expectations, which can influence wage and price-setting decisions, remain consistent with inflation returning to the target in the medium term (Section 4.4).

4.2 External cost pressures

Energy prices

Changes in wholesale oil and gas prices affect CPI inflation quickly through their impact on petrol prices and domestic gas and electricity bills. They can also have indirect effects on inflation, for example through their impact on production and transport costs, which take longer to feed through to consumer prices.

Dollar oil prices have fallen by 25% since the run-up to the November Report (Section 1), and sterling oil prices have fallen by a similar amount (Chart 4.2). As a result, fuel prices are expected to subtract 0.1 percentage points from CPI inflation in 2019 H1 (Chart 4.3), rather than pushing it up as projected in November. The oil futures curve — on which the MPC’s forecasts are conditioned — is now broadly flat. The projected contribution from fuel prices to CPI inflation further out is therefore a little higher than in November, when the futures curve was downward sloping.

Wholesale gas prices are lower than in the run-up to the November Report (Chart 4.2), but the main near-term influence on retail gas and electricity prices as measured in the CPI is likely to be the introduction of Ofgem’s price cap that affects most standard variable tariffs. As in November, that is expected to reduce CPI inflation by around 0.2 percentage points in 2019 Q1. But the price cap is now expected to be increased in April by more than previously anticipated, reflecting new information provided by Ofgem on its approach to estimating wholesale costs. That means that the projected contribution of gas and electricity prices rises in Q2 (Chart 4.3), pushing CPI inflation back to around the 2% target.

Non-energy import prices

The cost of non-energy imports facing UK companies and households increased substantially after sterling’s referendum-related depreciation in 2016. Import price inflation has fallen back markedly since, as the effect of the depreciation has waned.

The impact of non-energy import costs can be seen in the inflation rates of the more import-intensive components of the CPI basket — those that are imported or have a higher share of imported inputs. These have fallen since their peak in late 2017 as the impact of higher import price inflation has eased (Chart 4.4).

4.3 Domestic cost pressures

Developments in labour costs

Wage growth has continued to strengthen since the November Report amid tight conditions in the labour market (Section 3). Annual growth in whole‑economy regular pay — which excludes the volatile bonus component — averaged 1.5% between 2010 and 2014. But pay growth has since been strengthening, averaging 2.8% in 2018 H1 and 3.2% in 2018 Q3. Regular pay is expected to have grown by 3.3% in 2018 Q4 (Table 4.B), which would be the strongest annual rate of growth since 2008. According to the Bank’s database, median pay settlements rose to 3% in 2018, up from 2% a year ago and 1% two years ago. Some survey indicators of private sector pay growth have also strengthened in recent quarters (Table 4.B). Results from the Bank’s Agents’ annual pay survey are consistent with an increase in pay growth in 2019 (Box 4).

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. Measures of unit labour costs (ULCs) have picked up in recent quarters. Private sector unit wage costs (UWCs) based on the average weekly earnings (AWE) measure of regular pay exclude volatile components such as bonuses and non-wage costs and are also less prone to revision (see the November 2018 Inflation Report for a discussion). That measure rose by 2.1% in 2018 Q3, and monthly data suggest it picked up further to 2.8% in Q4 (Chart 4.5). This is high relative to its post-crisis average growth rate, but probably close to its target-consistent pace. Whole-economy ULCs show a similar picture of rising labour cost pressures. ULC growth on this broader measure was 2.3% in the year to 2018 Q3, and monthly data suggest the growth rate picked up further to 3.1% in Q4.

The composition of the workforce can affect average wage growth if jobs are created or removed in particular occupations, industries, or for certain qualifications. Changes in the composition of the workforce are estimated to have boosted average wage growth by just over ½ percentage point in the year to 2018 Q3, according to Bank staff calculations using Labour Force Survey data (Chart 4.6). If these were to unwind, then wage growth could fall back somewhat in the near term. However, these compositional effects should in principle affect measured wage and productivity growth in a similar way, so they should have less of an effect on ULC and UWC growth.

Growth of private sector UWCs is projected to rise a little further in the near term, supported by continued pay growth.

Other measures of domestically generated inflation

In addition to the different indicators of unit labour and wage costs, there are a number of other measures linked to the concept of domestically generated inflation (DGI). As explained in previous Reports, there are advantages and disadvantages of each measure and none perfectly captures the concept of DGI.

Most indicators of DGI rose over 2016 and 2017 (Chart 4.7). That is consistent with a gradual building of domestic inflationary pressures over that period, although some of the increase in those indicators was due to higher commodity prices and the effects of the referendum-related sterling depreciation.

By contrast, core services CPI inflation has fallen since mid‑2016. Despite rising slightly in the past few months, it remains some way below its pre-crisis average of 3½%. As discussed in previous Reports, some of the weakness in core services inflation can be explained by lower rents inflation. This partly reflects declining rents paid for social housing, as well as a sharp fall in rents inflation in London. Nonetheless, even excluding rents, core services CPI inflation paints a more muted picture of domestic inflationary pressures (Chart 4.8).

The combination of higher production cost growth and a fall in price inflation suggests that the margins of companies producing consumer goods and services have been squeezed. Margins are difficult to measure, but intelligence from the Bank’s Agents provides corroborative evidence of a recent decline. Contacts reported increasing competitive pressures across a number of different industries and in particular that the growth of online retailing has exerted pressure on the margins of bricks and mortar retailers.

Looking ahead, there may be conflicting pressures on margins. If competitive pressures continue, margins could remain compressed. In aggregate, however, margins tend to be procyclical, and given that some excess demand is expected to build over the forecast (Section 5), they would be expected to increase.¹

• Notes
  ¹ For more details, see Macallan, C and Parker, M (2008), ‘How do mark-ups vary with demand?’, Bank of England Quarterly Bulletin, 2008 Q2.

4.4 Inflation expectations

Inflation expectations can influence CPI inflation through wage and price-setting behaviour. The MPC monitors a range of indicators — derived from financial market prices and surveys of households, companies and professional forecasters — to assess whether inflation expectations remain consistent with the target.

Indicators of inflation expectations derived from financial market prices increased in 2018 H2 (Table 4.C). UK five‑year inflation swaps five years ahead rose by around 20 basis points, in contrast to dollar and euro equivalents. Market contacts attributed this in part to an increase in demand for inflation protection in the face of Brexit-related uncertainty. This indicator fell back somewhat in January. Market intelligence suggests that was in response to the publication of a House of Lords Economic Affairs Committee report, which made recommendations that would be expected to lower measured RPI inflation if adopted. Despite the recent decline, UK financial market indicators of inflation expectations appear a little elevated.

Other indicators of inflation expectations have generally remained stable (Table 4.C). The projections of professional forecasters remain close to the 2% target. Moves in short‑term and longer-term measures of households’ expectations were generally small. Companies’ inflation expectations fell back to around 2% in Q4.

Overall, the MPC judges that inflation expectations remain anchored, and that indicators of medium-term inflation expectations continue to be consistent with inflation close to the 2% target. The MPC will continue to monitor measures of expectations closely.