Falling Petrol Costs Brings UK Inflation Relief

With the economic recession tightening its grip and the effects of the extraordinary decline in oil prices since the summer feeding through into lower transport costs, inflation continues to abate fast in the UK.

In November, headline CPI inflation fell further, although less than expected to 4.1% year-over-year (consensus: 3.9%) from 4.5% in October, having peaked at 5.2% in September. With inflation still more than 1 percentage point above the Bank of England's 2% target, Governor King was still forced to write a letter of explanation to the Chancellor explaining the overshoot, as he is required to do--following the initial overshoot--every 3 months that the deviation remains persistent.

In his letter, King repeated the BoE's view--set out in the November Inflation Report forecasts--that the contracting economy would likely lead to a sharp fall in CPI inflation in coming months. King predicted that CPI inflation would probably reach the 2% target during 1H 2009 and that it was "quite possible" that it would fall "materially below" 1% in 2H 2009. King also warned that the undershoot of inflation below target "could persist for a while." Although King highlighted that the 2.5 percentage point reduction in VAT would add to disinflationary pressures during 2009, he noted that the combined effect of growing slack in the economy and the VAT reduction would be "moderated to some degree" by the dramatic decline in the sterling exchange rate. This stance suggests that the MPC is looking through the VAT reduction in its current deliberations, in our view. However, King did note that the reversion of the VAT rate back to 17.5% in a year's time will tend to push up the inflation profile in 2010. Although stating that the MPC had to look through temporary shocks and disturbances to the inflation profile, King's statement reinforces our view that interest rates will need to be raised fairly quickly from emergency levels once the economy gains some traction, probably late next year or early 2010, in our view.

The main driver for lower CPI inflation in November came, unsurprisingly, from falling transport costs due to a 9.3p fall in the price of petrol relative to 3.5p rise a year ago. Although there was a small upward effect from European-based airfares due to smaller seasonal price reductions last month compared to a year ago, the overall transport category still accounted for the bulk of the 0.4 percentage point decline in year-over-year inflation due to falling petrol prices.

Lower energy costs also led to a small negative 0.04 percentage point contribution from the housing & household services sub-component due to declines in heating oil last month compared to rises the same time last year. Still, relative to the remarkable decline in Eurozone inflation in recent months--from a peak of 4.0% in July to 2.1% in November--the fall in UK CPI inflation has been much more modest. In our view, this is largely due to the relative inertia of UK household utility prices for gas & electricity, which were hiked up anywhere between 15% and 25% in late summer but have yet to show any meaningful decline despite sharp falls in wholesale commodity prices. We believe that UK utility companies will probably only announce tariff reductions during 1Q 2009, which will then contribute to a sharp fall in headline inflation back to the 2% target early next year.

With retailers on the High Street under extreme pressure to discount prices of goods in the face of a sharp retrenchment in domestic demand, the clothing & footwear component subtracted a further 0.03 percentage points off headline inflation. With extensive and large discounts introduced from early December to boost footfall in the run up to the crucial Christmas shopping period, the clothing & footwear and household goods categories are likely to exert strong disinflationary pressures in the December data, in our view. Households discretionary spending on beer may also be under pressure, according to today's inflation data, as falls in the price of beer last month relative to rises a year ago saw the alcohol & tobacco subcomponent subtracting a further 0.02 percentage points to the 0.4 percentage point decline in headline inflation.

Despite disinflationary pressures from transport costs and parts of the High Street, fruit and vegetable prices bucked the trend by boosting inflation. Larger rises in the price of fruit and vegetables last month compared to a year ago led the overall food & non-alcoholic subcomponent to add 0.07 percentage points to headline inflation in November. Higher food prices help lift core CPI inflation unexpectedly to 2.0% year-over-year from 1.9% in October.

The alternative RPI measure of inflation fell a much larger than expected 0.8% mom last month (consensus:-0.6% mom) taking year-over-year inflation down to 3.0% in November from 4.2% the month before. Aside from lower petrol prices that are also included in the CPI measure, falling mortgage interest payments and the plunge in house prices--both of which are included in the RPI measure but not the CPI one--contributed a further 0.56 percentage points to the 1.2 percentage points decline in year-over-year RPI inflation last month. With house prices likely to plummet up to 30% from peak to trough, there is a very strong likelihood that RPI inflation will turn negative around the middle of next year in our view.

Intensifying recessionary conditions through 4Q are forcing retailers to discount prices of goods and services even more aggressively. As a result, we expect inflation will continue to fall dramatically in coming months. Sharp declines in household utility prices next year are likely to help push CPI inflation well below the Bank of England's 2% target from 2Q 2009 onwards. We expect that CPI inflation will probably bottom out well below 1% year-over-year during 3Q 2009 before recovering modestly towards the end of next year as the economy stabilises. Still, with risks to the economy firmly weighted to the downside, a more protracted economic slump could keep inflation lower for longer than in our central view. As the MPC attempts to lift the economy out of recession, we look for further 50bp rate cuts in both January and February to take the Bank Rate to a trough of 1%. We would not rule out that the fight against deflationary forces in the economy may see the BoE engage in some forms of quantitative easing if rates were to fall below 1%.

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