By Conor Lambe, Chief Economist at Danske Bank
The last two years have been challenging for UK consumers. Following the outcome of the EU referendum in June 2016, sterling depreciated sharply and UK inflation rose above the Bank of England’s target. This increase in inflation was not matched by the rate of wage growth and so consumers faced a squeeze on their purchasing power.
Earlier this year, the tide seemed to be beginning to turn, albeit only gradually. The rate of inflation was 3 per cent in January, but by April it had fallen to 2.4 per cent. It remained at that level for another two months, but the July and August data releases both showed the rate of price rises increasing again. Inflation in the UK now stands at 2.7 per cent, back at where it was in February.
The Office for National Statistics (ONS) provides commentary each month around how the prices of different goods and services have affected the headline inflation numbers. In July, the ONS signalled that an increase in the price of computer games and transport fares helped to push the overall inflation rate north. In August, there was upward pressure from cultural goods and services, transport services and clothing prices.
The prices of some individual items, such as computer games or theatre and concert tickets, can be quite volatile so care needs to be taken when assessing their impact on the headline inflation rate. But there are a number of broader factors that have been contributing to the higher inflation that has been observed over the last few months.
The first is the increase in the price of oil. At this time last year, oil cost around $56 per barrel. In recent days, the price of a barrel of oil has been slightly over $80. This increase in oil prices has fed through to higher petrol and diesel prices for car owners.
Another factor is the rise in domestic energy prices. The inflation rate for gas now stands at 4.3 per cent, up significantly from where it was in the first quarter of the year. The annual inflation rate for electricity has come down from where it was at the start of 2018, but it is still a relatively high 7.4 per cent.
Then there’s the exchange rate impacts. Analysing the value of sterling against a basket of other global currencies, known as the sterling effective exchange rate, shows that the value of the pound hit its post-referendum low in mid-October 2016. As mentioned above, it was this sharp fall that brought about the rise in inflation in the first place.
However, part of the reason behind the fall in inflation in the early part of this year was that sterling had appreciated slightly and the impact of the post-referendum depreciation was starting to fade. By the middle of April, the value of sterling was around 10 per cent above that October 2016 low.
But since then, and against the backdrop of heightened uncertainty around Brexit, sterling has lost some ground. At the end of September, the value of the pound was about 3.5 per cent lower than it was back in April. It’s still well above the October 2016 level, but this renewed weakness in sterling over the last few months likely played some role in the rise in the headline inflation rate observed over the summer.
To understand how high inflation has impacted consumers over the last two years, it is helpful to look at what is called real wage growth. Real wage growth measures the rise in people’s earnings, taking account of changes in the rate of inflation. In simple terms, it can be estimated by subtracting the inflation rate from the rate of nominal wage growth (the rate at which earnings have risen in normal cash terms). When real wages are rising, consumers have more purchasing power.
During much of 2017, real wage growth in Great Britain was negative. But in 2018, real wage growth has returned to positive territory as the rate of regular pay rises has been higher. The timing of the data releases for wage growth and inflation doesn’t quite match up month-to-month, but the latest data currently shows that regular pay increased by 2.9 per cent over the year to the three-month period ending in July. Inflation increased from 2.4 per cent in June to 2.5 per cent in July, and then to 2.7 per cent in August.
The key thing to note from these numbers is that inflation is still well above the Bank of England’s 2 per cent target and, despite now being positive, the rate of real wage growth is very modest. The squeeze on purchasing power may be less severe than it was last year, but households are still under pressure.
Looking forward, inflation is expected to remain above the Bank of England’s target for some months yet. But despite the rise observed recently, and the potential for inflation to bounce around its current rate somewhat over the short-term, the general trend over the next 12-18 months is still likely to see inflation coming down.
This is expected to be a consequence of the relatively modest growth in domestic expenditure in the economy and the impact of the initial sterling depreciation fading even further. Of course, this is assuming that an agreement is reached in the Brexit process which sees the UK leave the EU in a managed and orderly way.
The expected fall in inflation would ease the pressure on household budgets, but it is projected to be a gradual process, and so the consumer squeeze is likely to continue to be a factor over the rest of this year and into 2019.
This article was published in The News Letter on 2nd October 2018.