Costs and prices

4.1 Consumer price developments and the near-term outlook

After falling markedly over 2018, CPI inflation has been relatively stable at rates close to the target at the start of 2019. CPI inflation was 1.9% in March. It was also 1.9% in Q1 as a whole, marginally higher than the February 2019 forecast (Chart 4.1).

Inflation is expected to remain close to the target in the near term, with changes expected to be driven by energy price moves (Section 4.2). CPI inflation is expected to rise temporarily above the target in April, largely due to an increase in the Ofgem energy price cap which pushes up retail gas and electricity prices. CPI inflation is expected to dip below 2% in Q3 (Chart 4.2).

CPI inflation over the first half of the forecast is expected to be lower than projected in February, largely reflecting expected developments in retail energy prices. Wholesale gas and electricity prices have both fallen by around a third since the run-up to the February Report and that is expected to feed into retail prices. In addition, the 1½% appreciation of sterling since the February Report (Section 1) means that imported cost pressures — which are still judged to be pushing up inflation as a result of sterling’s previous referendum-related depreciation — ease slightly more rapidly than previously projected.

Over the rest of the forecast period, domestic cost pressures are expected to build (Section 4.3), pushing CPI inflation above the 2% target. Inflation expectations, which can influence wage and price-setting decisions, remain consistent with inflation being around the target in the medium term (Section 4.4).

4.2 Energy and import prices

Energy prices

Wholesale gas prices — which feed through into retail prices with a lag — have fallen by around a third since the February Report (Chart 4.3). Wholesale electricity prices have fallen by a similar amount. These wholesale prices represent an important part of retail energy companies’ costs and they are a key input to how Ofgem calculates the energy price cap that affects standard variable and pre-payment tariffs. Given the recent fall in wholesale costs, the cap — which is reviewed twice a year — is projected to fall in October, having risen in April, and that will feed into retail gas and electricity prices.

Sterling oil prices — which affect CPI inflation directly through their impact on petrol prices as well as indirectly through their impact on production and transport costs — have been volatile over the recent past, but are currently at a similar level to a year ago (Chart 4.3). The oil futures curve — on which the MPC’s forecasts are conditioned — is downward sloping. The projected contribution from fuel prices to CPI inflation further out is therefore a little lower than in February, when the futures curve was broadly flat.

Overall, the contribution of retail energy prices to CPI inflation is expected to fall in 2019, dragging on inflation by 0.2 percentage points in 2019 Q4.

Non-energy import prices

Higher import prices caused by sterling’s referendum-related depreciation (Chart 4.4) have pushed up CPI inflation in recent years. Pass-through of that depreciation to CPI inflation appears to have been broadly in line with the MPC’s assumptions so far, although there is uncertainty about its precise extent and timing. For example, it is possible that pass-through occurred faster than had been anticipated, but then also fell back more quickly, such that import prices are now pushing up CPI inflation by less than currently estimated.

Annual import price inflation rose to 2.6% in 2018 Q4 (Chart 4.4), higher than expected in the February 2019 forecast. Import price inflation is projected to turn negative in 2019 Q4, however, partly reflecting the 1½% appreciation of sterling since February. The effect of import prices on CPI inflation is consequently expected to diminish, both in 2019 and further out (Section 5).

The outlook for inflation will continue to be sensitive to movements in the exchange rate. The sterling ERI has been volatile recently and has been sensitive to news related to Brexit (Section 1). Box 5 of the February 2019 Report sets out how the projections for growth and inflation could be sensitive to different exchange rate paths.

4.3 Domestic cost pressures

Developments in labour costs

Wage growth picked up during 2018. Four-quarter growth in whole-economy total pay is expected to have remained at 3.5% in 2019 Q1, some way above its post-crisis average of 1.9% (Table 4.B). Annual growth in regular pay — which excludes the volatile bonus component from total pay — is expected to have been similar. According to the Bank’s database, median pay settlements were around 3% over the year to March, similar to at the time of the February Report. April is an important month for settlements, however, and much of those data are still to come.

Pay is growing at its strongest sustained pace since 2008. Previous episodes where wage growth has picked up since the financial crisis have proved to be transitory. In mid-2015, for example, pay growth rose to 3.1%, but fell back to 1.9% by the end of the year. Part of the pickup in pay growth during 2018 reflects compositional effects, which will probably unwind at some stage. But the main driver has been the tightness in the labour market, which is likely to persist (Section 3).

Survey data point to continued solid wage growth in the near term. Expected pay growth picked up in 2019 Q1 in the CBI surveys. According to the REC survey, pay growth for new recruits fell back slightly in 2019 Q1, but the survey still suggests that wage growth will stay close to current rates. Intelligence from the Bank’s Agents suggests that wage growth was robust but levelling off. The Agents’ contacts reported that companies with a high proportion of low-paid staff concentrated pay increases on employees who were on or just above the National Living Wage, which rose to £8.21 in April.

The extent to which the cost of labour affects companies’ production costs per unit of output depends on how it is growing relative to productivity. Unit labour costs (ULCs) can be volatile, but they have accelerated in recent quarters and grew by 2.8% in the year to 2018 Q4, as wage growth has strengthened and productivity growth has weakened (Chart 4.5). Monthly data suggest that ULC growth fell back slightly to 2.6% in 2019 Q1. Growth in private sector unit wage costs based on the AWE measure of pay was similar. These rates are above historical averages.

In the MPC’s central projection, unit labour cost growth is expected to remain robust and to contribute to a gradual building of domestic inflationary pressures (Section 5).

Other measures of domestically generated inflation

Non-wage indicators of domestically generated inflation (DGI) have generally been stable in recent quarters (Chart 4.6), but remain weak relative to ULC growth. In particular, core services CPI inflation remains some way below its pre-crisis average of around 3½%. This is an important measure because it focuses on a subset of the CPI basket which is largely domestically produced, as well as excluding some volatile components such as food and energy prices. Core services CPI inflation has been depressed by particular weakness in a small number of components, notably rents and insurance, but nonetheless continues to paint a relatively muted picture of domestic inflationary pressures.

The weakness of core services CPI could be linked to the same factors that caused the sterling depreciation around the time of the referendum. The depreciation may have partly reflected a judgement by financial markets that UK businesses selling tradable goods and services would be less competitive in future. That would be expected to raise the price of tradable goods and services relative to non-tradable ones. Some of that adjustment could have happened through lower inflation among the non-tradable components included in core services CPI, as well as through higher inflation among tradable components that are not.¹

The pickup in the growth rate of labour and other production costs and the fall in CPI inflation might suggest that companies’ margins in the consumer goods and services sectors have been squeezed. Margins are difficult to measure, but Bank staff’s indicator of profit margins among companies producing consumer goods has fallen back from its late-2015 high (Chart 4.7). The profit share — another proxy for companies’ margins — has also fallen slightly in recent years. The Bank’s Agents’ score for profit margins fell in 2017, although this has since partially reversed to around its series average.

• Notes
  1. For more details, see Tenreyro, S (2019), ‘The elusive supply potential: monetary policy in times of uncertainty’.

4.4 Inflation expectations

The MPC monitors a range of indicators of inflation expectations — derived from financial market prices and surveys of households and companies — to assess whether they remain consistent with the target.

Inflation expectations among households, companies and professional forecasters have given mixed signals recently. Household inflation expectations were little changed in the latest quarter, although there has been some upward drift in the short-term measures over the past year. Companies’ inflation expectations fell in the latest data, although these have been somewhat volatile in the past. The medium-term projections of professional forecasters fell slightly to 1.8% in 2019 Q2 (Table 4.C).

Measures of inflation expectations derived from financial market indicators increased in 2018 H2. Financial market inflation expectations at the one-year horizon have fallen back a little since, but longer-term measures have risen a little further (Table 4.C). This is in contrast to inflation expectations in the US and euro area, which have fallen over the past year.

Overall, the MPC judges that inflation expectations remain anchored. The MPC will continue to monitor measures of expectations closely.