The UK CPI and Its ‘Many Paths’

The United Kingdom is facing the same dilemma as other central banks as core inflation remains stubborn and headline inflation has dived sharply. The weakness in headline inflation has to do with its commodity components; we can particularly point to oil. On the other hand, core inflation, which shows some signs of moderating across most highly developed economies, shows a much slower progression, especially in the UK.

For example, the CPIH headline for the UK is up by 6.4% over 12 months; that pace drops to 5.7% at an annual rate over 6 months and to a skinny 2.3% annual rate over 3 months. If you look at the three-month rate and believe it, then you think the central bank is done! It's gotten inflation where it wants it. However, we know that's not true; we know that headline inflation is volatile; it's mercurial and, even though in the chart below we can see that inflation is declining on all the horizons, the war is not yet won.

Twelve-month, six-month, and three-month rates of inflation all are turning lower in Chart 2. But when it comes to the core rate of inflation which in this case is the CPIH excluding food, alcohol, energy, & tobacco, the inflation rate over 12 months is 6.4%, the same as the headline. But core inflation accelerates to an 8.1% annual rate over 6 months, then only drops back to a 5.6% annual rate over 3 months. The UK core rate over 3 months at a 5.6% annual rate is below its 12-month pace of 6.4% but not by a whole lot and it is not riding a clear trend either.

However, in the chart below, it's clear that this deceleration process is still in gear for the headline. We can tell that because the 3-month inflation rate continues to run consistently below the 6-month inflation rate and the 6-month inflation rate continues to run consistently below the 12-month inflation rate and all of them are decelerating! So, a decline in the inflation rate remains in progress in the UK.

Nevertheless, when we produce this same horizon for the core inflation rate, we get a very different result (Chart 3). First, none of the inflation rates not the 3-month, nor the 6-month nor the 12-month inflation rates are showing individual trends toward deceleration. Second, the strongest inflation rate is for 6-months, and it resides above the 12-month inflation rate, which is somewhat flat but with a noticeable uptrend. That tells us that the 6-month inflation rate is tugging the 12-month inflation rate higher. Until the last several months, the 3-month inflation rate had been surging; it was pointing to inflation acceleration, but it has since eased its pace over the last several months; it is now below both the 6-month and the 12-month rates, indicating that it is trying to pull the inflation rate lower. However, here the core inflation rate has been so volatile. We know that we can’t be very sure about what it’s really telling us or what it’s going to continue to do. It could reverse itself and show more inflation and acceleration next month as easily as it could continue its downtrend.

The data trends faced by the BOE While the UK faces the same challenges in inflation and particularly the paradox between the headline and the core inflation rate that it targets, the situation for the UK is worse because the underlying trends are not uniform or heading lower. They are chaotic. The Bank of England may not know or even have ‘a very good idea’ what to expect next. The diffusion calculations in the table show us that inflation accelerates period-to-period for 63.6% of the categories over 12 months (compared to 12-months ago) and over 6 months (compared to over 12 months). But over 3 months (compared to over 6 months), acceleration is present in less than 20% of the categories. Month-to-month inflation shows that in July with a 0.5% increase in the core rate and with the headline rate falling by 0.1% month-over-month. Inflation diffusion is at 54.5%, indicating slightly more inflation acceleration than deceleration in the month-to-month period. However, that comes after a skinny June diffusion value of only 9.1% and compares to a May diffusion value of 45.5%.

Unique inflation trends at work The UK faces a great deal of chaos in terms of its inflation signals. Sorting out where the trends are headed does not appear to be an easy job. In fact, it appears to be a job with a great deal of judgment in it. As we observe Bank of England policy, what we are going to observe - in my opinion - is the Bank of England pursuing a policy that protects against the outcome it wants to avoid the most. A menu of rate increases would tell us that the Bank of England is making sure that inflation does not accelerate further and that it turns lower. A Bank of England on pause for several meetings would tell us that it is not going to aggressively push inflation back down and make sure that it gets inflation deceleration in the short run. That would be a signal that the BOE is trying to achieve inflation progress while maintaining growth as much as possible… and, that it is willing to roll the dice on inflation in the short run. Central bank policy is going to be set to show us what the Bank is protecting against the most rather than what it really thinks is going to happen because it's almost impossible from these data and trends to have any kind of confidence on what's going to happen next with the inflation rate.

Having said that, there's a slight inclination for the unemployment rate in the UK to be heading higher and if the economy slows, quite apart from inflation trends themselves, the Bank of England might be able to reasonably expect that economic slowing will take pressure off prices and it might give the Bank some breathing room on the policy front. But as of now, there's very little that the Bank of England can sink its teeth into. The future is a roll of the dice, so policy must make a choice and take a stand.