UK Inflation Tumbles in October

Last month already, UK inflation began what is likely to be a steep descent which will probably see headline inflation fall convincingly below the Bank of England's target during 2H 2009 with a small risk of outright deflation, in our view.
 
In October there was a much sharper than expected drop across the board for UK inflation measures. Headline CPI inflation declined to 4.5% year-over-year from 5.2% in September (consensus: 4.8%). The  October drop was the first deceleration in the year-over-year rate since August 2007 and also the largest since the series was created in 1997. Even excluding volatile food and energy components, inflation fell below the 2% target to 1.9% in October from 2.2%. This was the first fall in the year-over-year core rate in 8 months and signalled that---as the economy contracted through into 4Q---disinflationary forces were not confined to the commodity space alone. Finally, RPI inflation, which is often used as a benchmark for wage agreements, fell to 4.2% in October from 5.0% (consensus: 4.5%). This was the biggest monthly decline in the year-over-year RPI inflation rate since January 1993.

Unsurprisingly, the largest downward effect on CPI inflation came from fuel & lubricants given the roughly 30% collapse in oil prices last month.  According to the ONS, the average  price of petrol fell by 7.1 pence per litre between September and October compared with a rise of 2.7 pence last year. As a result, the fuel & lubricant sub-component slumped 6.1% mom in October compared with a 2.8% mom gain the same time last year. Combined with a 6.2% mom fall in the price of airfares and a 12.1% plunge in the price of sea travel, the overall transport component alone subtracted 0.5 percentage points off the year-over-year inflation rate. 

The reduction in inflation pressures was not confined to the energy space. Food & non alcoholic beverage prices rose only 0.4% mom in October compared to a 1.6% mom surge a year ago. This subtracted a further 0.11 percentage points off year-over-year inflation. The only modest rise in food prices was caused principally by a 1.4% mom decline in the price of meat, partially offset by a 2.4% mom rise in the price of dairy products. There were also downward effects (-0.07 percentage points) from recreation & culture due to lower prices of DVDs and computer games. In addition, university tuition fees rose by only 6.2% mom last month following a 8.4% rise a year ago. This subtracted a further 0.04 percentage points off year-over-year inflation. There were also signs of sharper discounting on the High Street with prices for clothing & footwear down 0.6% mom in October whereas they were broadly flat 12 months prior. As the economy continues to contract and unemployment surges in coming quarters, we expect to see more aggressive price discounting from retailers which will further depress inflation in coming months, in our view.

Since RPI inflation includes a measure of house prices---which the CPI index does not---it could become negative next year as the full effect of the slump in house prices feeds through. The fall in RPI inflation last month was slightly greater than on the CPI measure (0.8% points versus 0.7% points, respectively). With food and energy price changes similar across the two indices, it appeared that housing costs made up the difference by subtracting 0.08 percentage points off year-over-year RPI inflation. Last month, the house price subcomponent in RPI fell 1.6% mom. However, this was partly offset by a 1.0% rise in rent---incorporated also into the CPI index. The 'housing depreciation' component in RPI tends to lag the main house price measures by at least 3 months. Currently, this measure shows house prices falling only 3.6% year-over-year, not nearly as severe as the roughly 15% year-over-year declines in the Halifax and Nationwide house price indicators, for instance. As the housing depreciation component likely catches up with more standard house price measures in coming months, it will exert an increasingly severe downward effect on RPI inflation which could fall below zero during next year.

The sharp drop in consumer price inflation last month is likely only the start of a process which could lead to a significant undershoot of the BoE's 2% target during 2H 2009. In part, the greater than expected drop in inflation last month validates the BoE's dramatic 150bp rate cut to 3.0% in November. Quite simply, with the economy already in recession and inflationary pressures in reverse following the slump in oil prices, rates at the 4.5% level were too restrictive, in our view. Today's sharp drop in inflation also keeps the door wide open for a deep 100bp cut to 2% at the MPC's December 3-4th meeting. We would not rule out an even larger cut next month as the MPC grapples with a sharply deflating economy.

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