Bank of England quarterly inflation report – facts not the hype

Unfortunately the majority of the press like to run pure scare stories about future Bank of England Base rate increases because they know it sells. However I like to run my quarterly updates on the inflation report to add a little more balance for readers.

The biggest news this quarter is private sector wage inflation increasing to 1.8% from being pretty much stagnant since the recession. Wages are a heavily weighted economic factor that influences real demand lead inflation however it is also balance out by output and productivity.

Wage inflation needs to be divided by any increase in output and productivity to get a better idea of its overall inflationary pressure. Current wage inflation has grown to 1.8% but overall output (GDP) has grown by 3.1% in the last year. Therefore as the BoE inflation target is 2% you can see that this is not yet a cause for concern on its own.

Unemployment has decreased to 6.8%, but this is still higher than what we think the natural rate of unemployment is at 5% and the BoE agents still think spare capacity ( the under utilisation of resources) in the economy is 1 – 1.5% of GDP. This “spare capacity” or “slack” means that an increase in demand, which would normally cause increase in prices, can be matched by an increase in supply with no extra price pressure.

This is why we have had the double good news of the economy improving with no predicted need to increase interest rates until some time next year and by only very gradual amounts with estimates of base rate being around 2% after 2017.

What about house price inflation I often hear people ask about? Yes house prices are now rising in all areas of the country for the first time, but it is skewed by London prices increasing by almost three times the national average. This (not so) micro economy is affected by far greater outside influences than the rest of the country such as foreign purchase of property assets.

However House prices on their own are not seen as a crucial indicator to the economy, and in fact total mortgage costs are not even included in the inflation figures (although interest rates are), so do not directly effect decisions made on interest rates by the MPC.

I actually think there is more cause for concern over the continuation of the UK’s recovery than any imminent small Bank Base rate increases. There are still fears that this is not a balanced recovery with consumer lead growth caused by the euphoria of a small improvement in the economy and current optimism releasing pent up demand for goods and services by running down household savings rather than any increase in productivity or business investment.

If we are seeing this increase in demand but not in prices it must mean there is plenty of slack and oversupply in the economy and hence little need for firms to invest. What we are also doing is sucking in imports with this demand helped by the recent strength of the pound making them more competitive and our exports less competitive.

Hence our balance of trade deficit is getting worse and this too could choke off the recovery. In the past you would normally see the balancing effect of the value of the pound weakening (from the trade deficit and money flowing out) causing an increase in exports (productivity) and decreasing imports. However with the money markets more concerned about chasing yields, and the continued purchase of UK assets (companies and property) from abroad, the pound is being kept artificially high on foreign exchange rates so we are not seeing this corrective measuring helping our home industry. What we were good at, selling banking services abroad, the demand for has virtually collapsed.

My summary is: yes the news is better, but we should remain cautiously optimistic with current predicted interest rate rises through continued recovery being best case scenario, because there are still a great many economic headwinds to negotiate.

All Graphs provided by the Bank of England