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Economy in Brief

U.K. Inflation Perks Up But Still Trends Lower
by Robert Brusca  February 19, 2020

U.K. CPIH inflation is moving higher in January, posting a sharp 0.5% gain in both the headline and the core. Over three months, the inflation rate is up. The year-over-year core rate is at 1.7% where it last was in November; it was higher at 1.9% in July of last year. The CPIH year-on-year gain was last higher in July of last year. Despite the recent pressure, inflation still seems moderate.

While there is a bit of push on U.K. inflation, there is nothing critical that has happened. There are concerns because of Brexit. The U.K. is widely expected to lose competitiveness at least initially as it exits and as it begins to distance itself from the rules of the EU.

The role of the exchange rate
The graph shows how the exchange rate and domestic inflation rate ‘play off’ one another. Causation can run either way from the domestic inflation rate to the exchange rate or from the exchange rate to the domestic rate of inflation. We see examples of both here. In 2010 and 2011, U.K. inflation spiked. In 2011, there was a mild depreciation of the pound sterling in reaction to rising inflation. Rising inflation makes the U.K. less competitive; a lower pound restores the lost competiveness. When inflation peaked and began to fall, sterling gained back its lost ground. U.K. inflation continued to fall into 2015. The drop in inflation boosted the exchange rate that soared to its high of this period. Then in 2016, the surprise Brexit vote took a sharp toll on sterling, exaggerated by a rate cut from the Bank of England. Sterling fell to new trade weighted lows for the current cycle boosting inflation back up to the neighborhood of 3%. But once the exchange rate stabilized, the inflation rate began to fall; it continued to fall to the 1.5% region where it has also ‘stabilized.’ Now there are concerns that as the Brexit after-game is sorted out, U.K. inflation might rise again.

However, the graph clearly slows a downtrend in the U.K. inflation rate since the Brexit announcement boosted inflation and a coincident trend rise in the weighted nominal sterling exchange rate.

U.K. inflation remains tame despite the widespread acceleration over three months. Inflation generally is still net lower over six months and is even-keeling-to-cooler over 12 months. The U.K. is sorting out new Brexit trade relations with the EU and the process is still adversarial. A new U.K. rule set has been adopted for visas with visas to be approved for skilled workers and not for the unskilled.

Looking ahead, more government spending is expected. For now global conditions are still rough-hewn as the past trade wars, concerns about new trade negotiations and the body slam from China’s coronavirus are holding back international commerce. On March 16, Andrew Baily will become the New BOE governor. The ECB already has a new president replacing Mario Draghi. And EMU monetary policy is in a bit of a state of flux again as Christine Lagarde has pledged to look into the effectiveness of the ECB’s super low and negative interest rate policy. And despite the low level of rates in the EMU, the euro area remains weak. German real GDP contracted in Q4 and even the Bundesbank is seeking stimulus from the German budget.

These are a lot of unsettled conditions and potentially significant policy shifts that are in train. We can only consider the future to be substantially unknown and unknowable. By comparison, U.K. growth, low U.K. unemployment and low U.K. inflation have been remarkably consistent. But some of that is because U.K. policy and the U.K. private sector have been on hold awaiting a decision on Brexit. Now that Brexit is done, the new concern is over what the new U.K.-EU trading relationship will look like and that is still under negotiation.

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