What does the fall in inflation mean for the economy?

21 May 2013

Inflation, as measured by the Consumer Prices Index (CPI), dropped to a seven-month low of 2.4% in April, providing significant relief for both consumers and the Bank of England.

Inflation was primarily reduced in April by lower petrol prices and lower air fares helped by Easter falling in March in 2013. In addition, core inflation retreated to a 41-month low of just 2%. The only significant upward impact on inflation came from higher food prices.

This was the first time that inflation had fallen back since September 2012 and gives incoming Bank of England governor Mark Carney greater scope for manoeuvre on monetary policy.

Drop 'welcome'

Even so, CPI of 2.4% in April is still putting an appreciable squeeze on households' purchasing power given that average weekly earnings actually fell 0.7% year-on-year in March and were up a mere 0.4% year-on-year in the three months to March.

"The downward move in CPI inflation is clearly welcome, particularly for households with pay growth having dropped to its lowest level since records began in March 2000," point out analysts at Investec.

What does this mean for monetary policy?

The easing of upside inflation risks facilitates further monetary stimulus by the Bank of England, should recent signs of improving economic activity falter or if the Monetary Policy Committee (MPC) feel that the economy could do with some extra fuel to try and build momentum.

Howard Archer, chief UK and European economist at IHS Global Insight, suspects the Bank of England will go for more quantitative easing once Mark Carney takes over as governor in July.

"We suspect that Mr Carney will be keen to try and build up escape velocity from the economy's extended softness and will be keen to establish his presence," he says. "Of course, Carney will only have one vote out of nine in the MPC as does Sir Mervyn King, but we suspect that he will be able to carry a majority of MPC members with him should he favour more help for the economy."

He adds: 'It also seems highly probable that the Bank of England under Carney will adopt the policy of giving guidance on the likely future path of interest rates.

"We do not expect the Bank of England to take interest rates below 0.5%."

What does this mean for stockmarkets?

"Such a big drop in inflation has hit the City like a double espresso shot, sending UK equities deeper into what we feel is overvalued territory," states Jamie Perkins, partner at the IFA Westminster Wealth Management.

"Inflation's growth-throttling squeeze on the economy has slackened substantially, but the stockmarkets' bull run should not be confused with real progress."

Inflation outlook

Archer acknowledges that CPI may move back up over the next few months, but stresses that it may not even reach 3% over the summer rather than going as high as 3.5% as had seemed likely earlier this year.

"Critically, underlying price pressures should be contained over the coming months by significant excess capacity, further moderate wage growth amid appreciable labour market slack, and limited scope for retailers to rise prices given still significant pressures on consumers," he comments.

Specifically, Archer is forecasting CPI inflation to stand at 2.7% at the end of 2013 and then trend down gradually to stand at 2.1% at the end of 2014. "There is a very real chance that inflation could finally get down to the promised land of 2.0% early in 2015," he adds.

This article was written for our sister website Interactive Investor

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