Has inflation peaked? Our analysis of a busy week for economic data

No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

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No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

Last month’s unexpected fall to 2.6% raised hopes that UK inflation had peaked, as the effect of the Brexit-induced weakness in the pound started to fade.

This week economists had predicted a slight uptick to 2.7%, but in the event it held steady at 2.6%, with falling fuel prices counterbalanced by higher prices for clothes, utilities and food.

It now looks quite possible inflation has peaked, and will fall back further in coming months. The year-on-year increase in producers’ raw material costs fell to 6.5% in July – undershooting forecasts for a 7.0% rise. This was down from 10% in June, the biggest month-to-month slowdown in almost five years. Input prices are a forward-looking indicator for consumer price inflation, as higher input prices are often ultimately passed on to the consumer, and therefore a lower number here could bode well for a fall in consumer price inflation down the line.

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Earnings beat expectations…

Wednesday saw the ONS release its monthly summary of the UK labour market. Average earnings growth exceeded expectations, with pay rising 2.1% year-on-year in the three months to June. When inflation is taken into account, however, real wages still fell by 0.5% in the three-month period.

The unemployment rate fell again, to a new multi-decade low of 4.4% – the lowest since 1975.

…but real wages are still falling

Source: ONS, Mar 01 – Jun 17

There is some cause for optimism that the squeeze on household finances could come to an end later this year, though ultimately the light at the end of the tunnel could be provided by falling inflation rather than rising wages.

Sustained pay growth could prove hard to come by. Conventional economic theory – the Phillips curve – suggests that with unemployment as low as it is, sooner or later demand for labour will outstrip supply and workers will be able to demand higher wages.

However a fundamental shift in the labour market has led this relationship to break down, meaning wages remain depressed despite low unemployment. The cause seems to be a lack of underlying inflationary pressure, combined with technological developments and global competition which has weakened the bargaining power of the worker. Throw continuing lacklustre productivity growth into the mix too, and the Bank of England’s prediction of 3% wage growth by next year could look optimistic.

UK consumer looks resilient

With wages falling in real terms, retail sales data is closely scrutinised as economists look for signs that consumer spending is coming under pressure.

Yet the UK consumer seems extraordinarily resilient. Spending has defied expectations of a slowdown since the Brexit referendum, and currently seems to be holding up despite weak wage growth and above-target inflation.

Retail sales rose 0.3% in July, matching June’s monthly increase and beating forecasts for a smaller 0.2% rise. Increased spending on food and household goods offset some weakness in other sectors.

This could bode well for economic growth – the UK economy is heavily reliant on the consumer, and economists had expected falling real incomes to eventually translate into weak retail sales.

If this fails to materialise the economy could see a stronger second half to the year – though there are also growing concerns over the level of household debt, which is fuelling continued consumption in the absence of rising real wages.

Low interest rates here to stay

All this has implications for interest rates. If unemployment can fall further without causing wage inflation, there is absolutely no pressure on the Bank of England to raise rates.

If inflation looks to be falling back towards the 2% target, this will allow the Bank of England’s Monetary Policy Committee to remove the sticking plaster of ultra-low interest rates very slowly indeed. With only two of the eight members voting for higher rates earlier this month, it seems even a return to 0.5% is some way off for now.

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This guide and article are not personal advice. If you are unsure of the suitability of an investment for your circumstances please seek advice.

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