Your Thoughts: Unexpected Inflation Fall

In June the UK’s inflation rate dropped unexpectedly to 2.6%, down from 2.9% in May. This comes as a surprise given the socio-political situation globally and in the UK, giving spout to the alarming degree of uncertainty businesses and the public are facing.

According to the Office of National Statistics (ONS), this was the first fall in inflation since October 2016, and was mostly due to lower petrol and diesel prices. Economists are now reportedly saying that this could cause the Bank of England to raise interest rates.

Below Finance Monthly has sought out several experts who could give their thoughts on the inflation fall, and what’s to be in months to come.

Markus Kuger, Senior Economist, Dun & Bradstreet:

The unexpected fall in the UK’s inflation rate is another sign of the economic uncertainty the country faces in the current political climate. Our analysis shows that the level of risk is ‘deteriorating’, with Brexit negotiations creating considerable unpredictability for businesses operating in and with the UK. This has only been intensified by the results of the general election in June, as the government’s narrow parliamentary majority is further complicating the process of leaving the EU.

Alongside the backdrop of an already slowing economy (the UK posted the lowest real GDP growth of all 28 EU economies in Q1 2017), a poll of business leaders after the election indicated a notable drop in business confidence. The best advice for businesses is to closely monitor the economic climate and the progress of EU negotiations, and use the latest data and analytics to assess risk and identify potential opportunities. As Brexit negotiations progress organisations should get a clearer picture of the future, but until then careful management of relationships with suppliers, customers, prospects and partners will be key to navigating through these uncertain times.

Kate Smith, Head of Pensions, Aegon:

Rapidly rising prices are almost always bad news for consumers, particularly pensioners on a fixed income, who are clearly having to go through a bit of belt tightening at the moment. The problem is amplified by both low wages and low interest rates, which give people little opportunity to grow their savings to meet the growing cost burden. There are lots of options available for people that want to diversify their investments outside of rock bottom savings account, but it’s important to plan ahead, and if dealing with significant amounts, consider seeking the input from a financial adviser.

Many of the younger generation seem to be prioritising current lifestyle over long term savings ambitions, and there’s nothing wrong with that in principle, but as inflation begins to bite it’s important they don’t start to see saving as an unaffordable luxury, and even consider sacrificing their workplace pension. By far the most effective means of saving is to do so early, and often, and there’s a risk that reducing regular contributions becomes a habit that’s hard to reverse.

Ranko Berich, Head of Market Analysis, Monex Europe:

Real wages remain in contraction and inflation is above target, but not above the BoE’s expectations. June’s inflation slowdown significantly reduces the chances of a near term rate hike as it vindicates the BoE’s last Inflation Report, and provides further fodder for the intensifying debate in the MPC about “looking through” the current inflationary shock.

The BoE’s last Inflation Report forecast inflation to peak around 3%, and this view remains intact after June’s CPI figures, although a marginal overshoot this year remains plausible. Although fuel prices were the main contributor to the slowdown, as a whole the release does not look immediately attributable to the sort of “transient factors” apparent in US inflation data, as several major basket categories made substantial negative contributions. Inflation in the UK is above target, but there’s nothing in June’s data to suggest an inflationary spiral of the sort that would entail an immediate rethink of monetary policy.

Sterling was looking rather frothy before the release, particularly against the greenback, and has been knocked down a notch as a result, as today’s release does reduce the likelihood of a hike in the immediate future. Thursday’s Retail Sales release will be crucial, unless consumer spending begins to recover from the shock seen in May it’s difficult to see how any of the centrist MPC members will be able to agree that policy normalisation is appropriate at any stage soon.

Edward Smythe, Economist, Positive Money:

While inflation may have fallen slightly in June due to lower fuel prices, it is likely that it will tick up back to 3% over the coming quarters. What should concern policymakers and businesses is that inflation is continuing to rise much faster than wages, which have only slightly improved in the decade since the financial crisis, putting pressure on households and forcing many on low incomes to rely on borrowing for everyday expenditure.

The Central Bank is in an increasingly difficult position. It may feel compelled to take action to meet the 2% inflation target, but raising interest rates could be catastrophic for an economy only growing weakly, and so reliant on personal borrowing and rising asset prices. This predicament highlights the need for policymakers to think seriously about new approaches to monetary policy which, unlike the current diet of quantitative easing and low interest rates, can help boost wages and reduce private debt.

Richard Flax, Chief Investment Officer, Moneyfarm:

With inflation at its highest level in nearly four years, you might expect that to increase the potential of an interest rate rise in the UK. But with wage inflation already lagging behind the latest Consumer Price Index (CPI), this isn’t necessarily a move that a lot of Brits could stomach. It’s now looking extremely unlikely that the Bank of England will increase interest rates in August.

Even if interest rates did rise, there is no way this could reach the levels that British savers are so desperate for, meaning those with excess savings sat in cash accounts should really start thinking about investing now to protect the value of their money over time. This is especially true for those saving for long-term goals such as retirement or helping their children through higher education. Millions of British savers could be in for a nasty surprise later in life if they find they can’t buy as much as they thought with their savings.

David Morrison, Senior Market Strategist, Spread Co.:

Sterling sold off sharply last week following the latest update on UK inflation. The headline Consumer Price Index (CPI) for June rose 2.6% when compared to the same period last year, and this was down sharply from +2.9% in May. Most of the decline could be blamed on a fall in oil prices and the British pound. However, inflation measures which exclude energy were also weaker, suggesting other factors were at play as well.

UK inflation has soared since the end of 2015 when year-on-year CPI was actually negative. Yet despite the pull-back last month it is still well above the Bank of England’s 2% target. Nevertheless, the consensus opinion seems to be that the pressure is now off the Bank to raise rates at next month’s key meeting. This is when the Bank’s Monetary Policy Committee (MPC) delivers its quarterly inflation report and is therefore a perfect opportunity to announce a change in monetary policy.

Before last week’s drop in inflation, many analysts expected a rate rise next month. For a start, there were a number of commentators who considered last year’s rate cut in the aftermath of the Brexit vote particularly ill-advised. Reversing it twelve months later would seem a sensible route to take.

This opinion gained traction after the MPC vote unexpectedly shifted from 7-1 against a rate cut to 3-5 in favour at their last meeting back in June. However, Governor Mark Carney is notoriously dovish, so he now has additional ammunition to urge caution from his colleagues next month. But the worry for Mr Carney and his dovish colleagues is that it’s dangerous to look at a single data point and extrapolate from it a change in trend.

If last weeks’ fall in inflation turns out to be a blip rather than the start of a steady decline, then it won’t take long for the Bank’s critics to accuse it of taking its eye off the ball.

Kerim Derhalli, CEO of invstr:

The UK has recently experienced a surge in inflationary pressure with, unsurprisingly, Brexit as the main culprit. As a nation, we love to consume foreign goods and the devaluation of the pound following last year’s referendum result made all of our imports more expensive. It also caused mayhem for economists and legislators looking to predict what is to come.

However, as the impact of this one-off devaluation event recedes, the inflation rate has started to level out and come down.

There are other economic factors too that are likely to put downward pressure on inflation. Wage growth has been lower than the overall level of inflation which has squeezed living standards forcing people to borrow more or spend less. Already low savings levels and high consumer debt suggest little capacity among Joe Public for higher prices. The uncertainty around the investment climate caused by Brexit has also impacted the housing market keeping both home prices and rents subdued. Outside of the UK, international energy prices continue to remain relatively low too helping to keep inflation in check.

What could change? One factor to consider is the current domestic political debate about higher domestic wage settlements in the public sector, which could help to drive up prices. Plus, as we learn more about the UK’s international standing in the world going forward, there are sure to be factors that economists haven’t even begun to consider that will throw their prediction models into disarray. Forecasting either growth or inflation rates is unlikely to get any easier anytime soon.

Jamie Smith-Thompson, Managing Director, Portafina:

Inflation is especially going to hit those pensioners with an annuity. Although there is an option to inflation proof an annuity when it is first taken out, most people decide not to factor it in because the benefit leads to such a reduction in income in initial retirement. Consequently, the majority of pensioners with an annuity will be on a a fixed income. The knock-on effect is as inflation increases, their purchasing power reduces. The longer you are in retirement the less money you will tend to have in real terms and sadly it is in later retirement when that money is needed for care and support. This is all a powerful reason why it is important that the triple lock remains on the state pension to provide some degree of protection.

One of the key questions people ask themselves as they consider their retirement is “How am I going to take the income?” and inflation and death benefits should be a primary factor to bear in mind when looking at what’s out there. The two primary options are drawdown or annuitys. If you want to factor in inflation-proofing into your annuity you could reduce your initial pension income by around 30%. Apart from the huge reduction itself, it is an unattractive proposition because most people are more likely to need greater income in the initial part of retirement, as this is when they are more active. For this reason, annuities are not as popular as they once were. Drawdown on the other hand takes inflation into account by default. Drawdown remains invested so if inflation goes up, the markets usually go up as well. It is far more flexible and it allows the owner much more control in terms of the state of the economy.

Adrian Slack, Senior Trader, Learn to Trade:

Since the UK's vote to leave the EU last year, the value of the pound has continued to depreciate. This stimulated an increase in the cost of imported goods and raw materials prompting an increase in inflation.

As the value of sterling continues to fall, households should expect to feel the pinch of higher costs on everyday imported goods in their baskets and on European holidays. Businesses should also expect to incur higher costs for doing business in Europe – they need to plan carefully when buying goods from overseas to lessen the blow on a potential fall in business profits. Exporters will continue to benefit as sterling’s fall makes UK goods more competitive overseas.

Moving forward, we expect inflation rates to creep back up steadily due to sterling’s continued weakness due to political risks resulting in higher import costs and fundamentally increases in prices to purchase. Whether this leads to a rise in interest rates is still to be confirmed. There’s an entire generation on low mortgage rates and so any increase in interest rates will have a negative effect on the housing market. We are in a bit of a catch 22 at the moment. With Brexit negotiations underway, it’s difficult to say how high inflation rates are likely to go.

Ana Boata, Economist for Europe, Euler Hermes:

June’s lower-than-expected inflation rate is mainly due to base effects linked to the summer discounting of some goods’ prices and the appreciation of the Sterling in April and May. These effects should already fade away in July and we expect the inflation rate to approach but remain below 3.0% year-on-year this autumn.

Looking towards 2018, the growing economic uncertainty surrounding Brexit will continue to hamper sterling. Increasing import costs will continue to put upward pressure on inflation, which will hit 2.7% on average in 2017 and 2.6% in 2018. This will act as a drag on consumer confidence and trigger a significant slowdown in consumer spending growth to 1.9% (from 2.8% in 2016) and 1.2% respectively.

GDP growth is expected to slow down to 1.4% in 2017 and 1.0% in 2018 which, coupled with the weakness of Sterling and the rise in inflation, would argue for a smooth rate hike in H2. This should support households’ real purchasing power and help avoid a sharp adjustment of the residential housing market.

From 2019, the level of inflation will be heavily influenced by the UK’s trading relationship with Europe. We forecast that a transition deal – where the Single Market conditions would still be kept for defined period of time – is the most likely outcome. This should be seen as a good news and help Sterling stabilise somewhat. Inflation should moderate slightly to 2.4% in 2019 and 2.3% in 2020. Without a transition deal, inflation would likely reach a high level of 3.5% in both of those years.

High levels of competition, increasing discounter market share and an online shopping frequency more than twice the European average have already made the UK retail sector of the most challenging in the world. In addition, growing financial stress, highlighted by a 10pp increase in net gearing ratios last year with average profits (EBIT) slipping by 1.4pp to 5.6%, is expected to place greater pressure on cash flow and payment terms throughout the retail supply chain.

Salvador Amico, Partner and head of the Brexit team, Menzies LLP:

The fall in the rate of inflation has come as a surprise but businesses, consumers and the Bank of England alike are unlikely to be celebrating too much at this stage.

Future economic and market-driven volatility is still expected. Inflation rates could creep back up and the pound will remain volatile, hindering long-term investment plans. To avoid losing out, businesses should take steps to minimise their exposure to such volatility by re-assessing their supply contracts, distribution networks and hedging against currency fluctuations.

To date, there has been a reluctance from businesses to pass on extra costs to the consumer in the form of price rises, but this could become harder to avoid in future. In the meantime, businesses will remain focused on removing cost where it is possible to do so by renegotiating contracts and relocating supply chains closer to home.

Inflation rate fluctuations are usually an indicator that change is on the horizon and speculation over whether the Bank of England is likely to raise interest rates in the coming months will also be causing concern. However, with consumers being squeezed on a number of levels and wage inflation continuing to lag, it would be surprising if interest rates rose before the end of the year. With the economy hugely dependent on consumer spending, taking disposable income out of their hands would be counterproductive.

One of the key challenges facing businesses at the moment is exchange rate volatility. By now, the impact of recent falls in the value of the pound have worked their way through the system and this could mean that the economy is starting to stabilise.

This has been a year of curveballs and, as we have seen, it can take just one shock change to unsettle the entire business community. For the time being, however, inflation rates appear to be moving in the right direction and we should be grateful for that, even if we know it is unlikely to last.”

We would also love to hear more of Your Thoughts on this, so feel free to comment below and tell us what you think!