UK inflation is about to take off – but by how much?

September 1, 2016

Lurking beneath the surprisingly strong rebound in manufacturing shown by the latest Markit/CIPS PMI, there were clear signs that inflation is about to shoot higher –and perhaps in a big way.

The survey’s input prices index, which gauges changes in the average price of goods purchased by manufacturers, rocketed five points in August to 67.1 – its highest since May 2011 and fuelled by the pound’s plunge since June’s Brexit vote.

While the PMI adds to evidence Britain’s economy has avoided an immediate hit from the vote to leave the EU, it also confirms economists’ worries about the longer term:  higher inflation will eventually hurt consumer demand, one of the few pillars of economic growth.

The PMI’s input prices index has a decent correlation with consumer price inflation about five or six months later.

A quick read-across from the current level of the input prices index suggests consumer price inflation could top 3 percent next year, although the headline rate of inflation is starting from a much lower base than in 2008 or 2011.

What is crystal clear, however, is that the weak pound – still down about 12 percent against the dollar since the referendum – is only just starting to feed through into inflation.

The composition of the official measure of producer input price inflation has already shifted, and is now being driven by the cost of imported goods.

Figure K- Input PPI inflation and contributions to the input PPI annual rate, 2014 to 2016

Chart credit: Office for National Statistics

The PMI’s input prices index has jumped more than 14 points in the last three months, a run matched only once in the last 10 years, and it shows no sign of slowing down.

The consensus of economists polled by Reuters last month showed inflation looks set to rise to 2.4 percent around this time next year, from 0.6 percent this July.

That would wipe out the real wage gains that British workers have only just recently won back after years of decline.

Those institutions forecasting inflation north of 3 percent – Fathom Financial Consulting and Nationwide Building Society – will be feeling pretty confident right now.

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