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Don't worry about UK inflation

With international inflation low and UK companies cutting costs, UK inflation is unlikely to overshoot the Bank of England's target.

Markets and economists were surprised by the pick-up in UK inflation in January. The “underlying” rate of retail price inflation, which excludes mortgage interest rates, jumped by over a third – from 1.9% to 2.6% – moving into the top half of the Bank of England’s 1.5% to 3.5% range for the first time since last Summer.

Prior to this jump, this key inflation measure had been on a gradual downward trend, prompting some commentators to speculate that Sir Edward George would soon have to write to the Chancellor to explain why inflation was too low (ie, below 1.5%). Now the talk is of higher interest rates to head off a surge in inflation. So which of these views is correct?

Inflation in the UK is the product of international and domestic influences. The international economic climate affects the UK in two ways. Global inflationary pressures have a direct effect on UK inflation because of the many goods and services that we import from overseas, while the state of the global economy has an indirect impact on inflation here because it influences the level of demand for UK products in overseas markets.

On both these counts, there is little sign of any immediate inflation threat. Inflation in the other major economies remains subdued – it is below 2% in the US and 2.5% in the eurozone. In Japan, prices are falling sharply, highlighting the fact that deflation is still a real danger. Oil and commodity prices are also subdued and, across the industrialised world, factory-gate prices are falling (compared with annual price rises of 4% to 6% just a year ago).

There are signs that the global economy will pick up over the course of this year, but – as I argued last month – the pace of recovery is likely to be quite slow. In Germany and Japan, retail sales are falling sharply, and in the US the recovery in consumer confidence has faltered. Consumer spending – which has so far held up well – is unlikely to continue to be so supportive of growth, at least in the short term.

With international economic influences still consistent with low and falling inflation, concerns about a pick-up in UK inflation hinge on the impact of domestic economic forces. Here, the evidence is mixed. Retail spending ended strongly last year, but surveys and analysts’ reports released so far this year point to a slowdown. The housing market has also been cooling off despite low interest rates, and, according to the latest average earnings data, wage increases have continued to ease. Low headline inflation (currently at 1.3%) will reinforce the downward pressure on pay.

On the other side of the equation, there was an unexpected fall in unemployment in January and service sector inflation is running at its highest level since 1993. The worries about higher inflation rest mainly on a pessimistic extrapolation of these indicators.

However, over the course of this year, many companies will continue to reduce employment and vigorously curb costs as they seek to rebuild their profit margins. (The recent announcement from my own company, British Airways, is just one of many pointing in this direction.) The impact of this UK corporate cost-cutting on employment trends and resulting job security concerns should act as a brake on consumer spending and service sector price increases.

Over the past five years, the Bank of England has been remarkably successful in keeping inflation at around its central target of 2.5%. The most likely outlook is for this record of success to continue, preventing Sir Edward from having to pick up his pen and write to Gordon Brown. There are some upward influences on domestic inflation, but these are being offset by continuing pressure on companies to cut costs and reduce employment. The international climate is also likely to remain supportive of low inflation.

However, this optimistic outlook does not mean that we will not see a rise in interest rates over the course of this year. The Bank of England has to think up to two years ahead in setting the course for interest rates. The current level is below the “norm” of 5% or so which we might expect in steady economic conditions – so borrowing costs are likely to move up to this level over time. However, in the absence of an unexpectedly strong rebound in the global economy, any upward adjustment in UK interest rates is likely to be modest and gradual.

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