The larger-than-expected drop in CPI inflation, from 2.5 per cent in June to 2.0 per cent in July is only a temporary pause before CPI inflation surges to above 4.0 per cent by the end of the year. Crucially, though, we expect this surge in CPI inflation to be temporary. Indeed, CPI inflation should be back below the Monetary Policy Committee’s (MPC) 2.0 per cent target by the end of 2022. Of course, the risk is that CPI inflation proves to be stickier than we expect, which could push the MPC into raising rates before the economy has fully recovered.
The drop in the CPI inflation was mainly driven by weaker inflation in clothing (3.0 per cent in July 2020 vs 1.7 per cent in 2021), and recreation and culture (2.1 per cent vs 0.7 per cent). The sharp price rises in those sectors as they reopened in July 2020 fell out of the annual comparison.
But we know that this is just a brief pause for CPI inflation on its way to 4.0 per cent or higher by the end of the year. The recent rises in food, oil and energy prices will all push up inflation over the rest of this year (see chart). What’s more, international shortages of key materials will continue to cause goods inflation to rise.
The lack of availability of semiconductors has hampered the production of new cars, which has in turn crimped the supply of second-hand cars as people delay upgrading. As a result, the price of second-hand cars jumped by a whopping 14.4 per cent y/y in July.
And there is clear evidence that higher costs are feeding through into higher prices for goods leaving the factory. PPI output prices jumped from 4.4 per cent in June to 4.9 per cent in July.
The upward pressures on inflation from food, oil and energy should all fade over the second half of 2022. As supply chains return to normal, goods price inflation should also wane. By next year most of the pandemic-related increases in prices will also have faded. Indeed, the unexpectedly large drop in inflation in July is a prime example of just how quickly inflation can fall.
We expect inflation to be back at the Bank of England’s 2.0 per cent target by the end of next year. That’s a little quicker than the MPC expects, but that’s largely because we think there has been less permanent economic damage from the pandemic than the MPC thinks. If true, this would allow the economy to run hotter for longer without generating inflation.
The rest of the year won’t be pretty for some MPC members, but we think the MPC will look through the upcoming rise in inflation as it’s largely driven by temporary external factors. It said at its meeting earlier in August that it expected inflation to peak at around 4.0 per cent at the end of the year. That’s why we don’t expect the MPC to start tightening policy until late 2022 or early 2023, rather than mid-2022 like financial markets do.
However, there are two major risks.
First, more of the recent surge in earnings growth could be related to underlying pay growth than we think. This would permanently boost firms’ costs, and could feed through into higher inflation.
Second, a period of above target price rises may prompt consumers to reassess their inflation expectations, which could feed into wages and prices and make inflation more permanent.
But as long as underlying pay growth and inflation expectations do not rise significantly, we think inflation will fall back below 2.0 per cent by the end of 2022 and give the MPC some breathing room.