UK inflation in November came in higher than expected, but we think that concerns over a damaging rise in prices over the next 12-18 months are overdone.
On the face of it a sharp rise in inflation looks likely, with worrying implications. UK imports account for 30% of GDP and trade-weighted Sterling is 15% lower than last year’s highs. Taken together this implies that the UK price level should be cumulatively 5% higher than would have otherwise been the case and suggests that inflation could well rise beyond the 3% level. This will be negative for consumers, as the rise in prices is likely to be greater than the growth in wages.
It’s hard to refute the notion that a substantial decline in the value of Sterling will contribute to higher inflation. However, the powerful disinflationary forces – ie price cuts – at work on the high street need to be taken into account. The retail sales deflator – a measure of price falls – is currently running at -1.3% an annual basis and what is noteworthy is that this is despite the fact that trade weighted Sterling is 15% lower than the level we saw more than 18 months ago.
Most retailers’ foreign exchange hedges established at that time should have rolled off by now, but we have yet to see a rise in high street prices. This is reminiscent of what happened when we saw a depreciation of a similar magnitude in 1992, when Sterling exited the Exchange Rate Mechanism. Most commentators at the time were negative on the UK outlook, with the risk of stagflation, which is persistent high inflation combined with high unemployment and stagnant demand, the predominant concern. In the event inflation did not really rise and the economy benefitted from the ease in financial conditions represented by weaker Sterling and lower interest rates.
Turning the present situation, price falls are a consequence of the ultra-competitive environment in the retail sector, reflecting the increased presence of discounters and the secular trend of increasing internet usage.
If we turn to the labour market for a moment, despite the bearish narrative around hiring intentions, unemployment has remained on a downtrend, vacancies are near 16-year highs and labour income growth has been reasonable. In fact, a case can be made for these relatively-tight labour market conditions feeding through to further gains in labour incomes, offsetting much of what we think will be a less headline-grabbing rise in high street prices than many commentators are expecting.
The above article by Jon Cunliffe, Chief Investment Officer at Charles Stanley, was first published by Charles Stanley on 15th December 2016.