Schroders: Falling UK inflation to spur domestic demand

UK CPI came in at 0.0% in February, lower than expectations for +0.1%. This represents the lowest level of inflation on record. 

The major cause for the fall in the headline rate has been well-documented and the Office for National Statistics estimates that 0.9% of the decline relative to February 2014 (+1.7%) can be attributed to disinflation in food and petrol prices. Core CPI inflation was a more steady +1.2%.

Prices in a number of consumer services segments, such as restaurants & hotels and education, increased at similar rates to a year ago, suggesting that consumer demand in the UK remains stable. Meanwhile producer prices showed substantial declines in input prices (-13.5%) and more mild disinflation in output prices (-1.8%), which should serve to support company margins as well as the outlook for the labour market. House price inflation remained robust at +8.4%.

Taken together, we are inclined to agree with the Bank of England’s analysis in February’s Inflation Report that the fall in energy prices over the last six months has been largely driven by an increase in global supply rather than a fall in global end demand, which means that the recent decline in inflation should be positive for domestic demand (consumer spending and business investment) and serve to prolong the UK’s business cycle. 

If end demand remains positive, then falling prices should not feed through into wage negotiations and the current low rate of inflation is, therefore, likely to be temporary. In the short-term this means that the UK’s interest rate trajectory is more likely to be driven by labour market data than movements in the headline inflation rate. Our expectations for continued growth in the UK economy and a (long-awaited) corresponding pickup in wage growth are unchanged.