CPI surges but it's a damp squib for the market
Posted on 18 January 2011 by
Today’s inflation figure of CPI 3.7% year on year will provide plenty of copy for the news media but the market’s reaction hardly justifies the Evening Standard headline of “Soaring interest rate on the way.”
The 5 year UK gilt yield has risen only 4 basis points today, less than the 7 b.p. increase in the 5 year German Bund and about the same as the 3 b.p. increase in the US 5 yr Treasury Bond. This small increase and relative outperformance against the equivalent German Government stock suggests market sentiment on the timing of a rate rise has not changed dramatically!
The MPC will have seen an early draft of the inflation figures last week before setting Bank Rate and the figures are clearly a negative on the inflation front. However, an analysis drilling down into the detail suggests lurid newspaper headlines are most definitely not “clear, fair and not misleading!”
CPIY, which is CPI excluding indirect taxes, increased from 1.6% to 2.0% in December, matching its joint high for 2010. This figure is of course bang on the target rate and demonstrates how much indirect taxes are contributing to the inflation numbers. For the record RPI only increased by 0.1% to 4.8% and RPIX was unchanged at 4.7%.
The main contributors to the inflation increase were energy and food. Electricity prices were up 1.2% on the month and gas prices up by 4.6%. Petrol and diesel costs increased even more, by 2.8%, compared to almost no change in December 2009. Rising crude oil costs pushed the price of other fuels up a staggering 13.1%. Food price inflation accelerated, no doubt partly reacting to the disruption following the snow in December and global weather catastrophes.
It is a brave person who predicts the price of oil and in 6 months time. It could easily be $20 a barrel higher or lower. Hence predicting its impact on inflation is fraught with difficulty but the MPC cannot influence it. The trends impacting on the December inflation numbers are likely to continue in January, probably resulting in CPI hitting the 4% forecast by the MPC sooner than previously expected. However, what is more important is what it peaks at rather than how long it takes to get there.
What we do know is that inflation will fall back early next year when the VAT rise falls out of the year on year calculation. Tomorrow we get the labour market figures but wage increases are currently running at 2.2%, with unit labour costs rising by only 1.5% p.a. This is a key figure because as long as inflation doesn’t feed through to wages there is less pressure on the MPC to increase rates.
Increased commodity prices and increased taxes, plus the other austerity measures, have a similar effect on consumers as an interest rate rise, making the case for a rate rise more difficult. I still expect Bank Rate to stay at 0.5% until the second half of the year and then only rise slowly, but the cost of fixed rate mortgages will rise further in the short term.
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