Inflation Report, May 2015

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Overview

GDP growth was robust in 2014, moderating in the second half of the year. Despite the weakness in 2015 Q1, the outlook for growth remains solid. Household real incomes have been boosted by the fall in food, energy and imported goods prices. The absorption of remaining slack and a pickup in productivity growth are expected to support wage growth in the period ahead. Along with the low cost of finance, that will help maintain domestic demand growth. Activity in the United States and a number of emerging markets has slowed but momentum in the euro area appears to have strengthened over the quarter as a whole.

CPI inflation was 0.0% in March 2015 as falls in food, energy and other import prices continued to weigh on the annual rate. Inflation is likely to rise notably around the turn of the year as those factors begin to drop out. Inflation is then projected to rise further as wage and unit labour cost growth picks up and the effect of sterling’s appreciation dissipates. The MPC judges that it is currently appropriate to set policy so that it is likely inflation will return to the 2% target within two years. Conditional on Bank Rate following the path currently implied by market yields — such that it rises gradually over the forecast period — that is judged likely to be achieved.

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Money and asset prices

In the United Kingdom, official interest rates remained at historically low levels, and the market path continued to suggest very gradual rises over the next three years. The European Central Bank’s asset purchase programme has been associated with lower long-term interest rates and contributed to an increase in euro-area equity prices. The sterling effective exchange rate rose by around 2%. Household borrowing rates remained low and unsecured lending to individuals continued to grow.Companies continued to raise net external finance.

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Demand

Despite some slowing in the second half of the year, demand growth was robust in 2014. That was supported by robust household consumption growth, funded by a recovery in real income, which is expected to continue in 2015. Business investment growth weakened in 2014 H2, but is expected to recover in 2015. Despite subdued world demand growth, net trade made a positive contribution to GDP growth in 2014. The outlook for the euro area has improved and world demand growth is projected to rise a little in 2015.

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Output and supply

Output growth is estimated to have slowed to 0.3% in 2015 Q1, but is expected to be revised up to 0.5%. Four-quarter hourly productivity growth remained weak. Survey indicators suggest that capacity utilisation among companies eased slightly, but remained around normal levels. Total hours worked increased in the three months to February, as strong employment growth outweighed a modest fall in average hours. The unemployment rate fell further. Following a review of the evidence on potential supply, the MPC’s best collective judgement is that the degree of slack is broadly in the region of ½% of GDP.

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Costs and prices

CPI inflation was 0.0% in February and March. The current low level of inflation can largely be explained by lower energy, food and imported goods prices, although it also reflects subdued growth in domestic costs. Inflation is likely to remain around zero in the very near term. Sterling oil prices, although higher, remain around 40% below their mid-2014 peak. Wage growth remained weak in early 2015. Inflation expectations remain broadly consistent with the MPC’s 2% target.

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Prospects for inflation

CPI inflation was 0.0% in March, well below the MPC’s 2% target. That undershoot largely reflects falls in the prices of commodities and some other imported goods. Those falls will bear down on inflation for much of this year, but the path of inflation thereafter is expected to depend more on domestic cost pressures. Domestic pressures have been weak, as seen in low wage growth in recent years. They are likely to build over the forecast period, as a steady expansion in demand absorbs the remaining economic slack. The MPC judges that it is currently appropriate to set policy so that it is likely that inflation will return to the 2% target within two years. Conditional on Bank Rate following the path currently implied by market yields — such that it rises gradually over the forecast period — that is judged likely to be achieved.

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