UK CPI inflation surprised on the upside in May and on the downside in June. The “big picture” is that it is above the MPC’s forecast and will probably still reach 3.0% later in 2017, despite lower-than-expected energy prices.

Annual CPI inflation fell from 2.9% (2.87% before rounding) in May to 2.6% (2.64%) in June. Lower motor fuels inflation accounted for 11 basis points of the decline (i.e. about half) with the remainder due to “core” components.

CPI inflation averaged 2.74% in the second quarter, above the MPC’s forecasts of 2.65% and 2.43% in the May and February Inflation Reports respectively. The overshoot would have been larger but for a lower crude oil price than the MPC assumed.

Reasons for expecting inflation to reach 3.0% later in 2017 include:

1)    Despite a slower monthly gain in June, core* prices rose at a seasonally adjusted annualised rate of 3.0% in the latest three months from the previous three – see first chart. Annual core inflation of 2.4% in June would rise to 2.9% in October if this pace of increase were to be sustained.

 
2)    Annual core** producer output price inflation rose to 2.9% in June and usually peaks ahead of core CPI inflation, i.e. it also suggests a further increase in the core CPI rate – second chart.


3)    The headline / core gap is likely to remain positive and may widen, reflecting stronger food price inflation and a stabilisation of energy inflation after a recent slowdown (assuming stable crude energy costs). CPI food inflation rose further to 2.6% in June but is significantly lower than would be expected based on historical relationships with producer output price inflation for food products (5.8% in June) and the annual increase in the FAO’s global food commodity price index, expressed in sterling (19% in June, down from a peak of 36% in January) – third chart.


*Excluding energy, food, alcohol, tobacco and education, and adjusted for the estimated impact of VAT changes.
**Excluding food, beverages, tobacco and petroleum.

A fall in Chinese money growth since late 2016 has been reflected in an easing of inflationary pressures rather than a loss of economic momentum. Current monetary trends are judged here to remain consistent with respectable economic expansion, while the PBoC has started to reverse recent policy tightening, which may prevent a further slowdown.

Annual growth of real GDP was 6.9% in the second quarter, unchanged from the first quarter and above the consensus forecast of 6.8%. Nominal GDP growth fell from 11.8% to 11.1%, reflecting a slowdown in the price deflator – see first chart.


The decline in nominal expansion is consistent with an earlier fall in annual narrow money growth, as measured by “true” M1*, from a peak in August 2016. This eased further to 13.9% in June but is much stronger than in 2014 / early 2015, when the economy was at risk of serious weakness / deflation – second chart.


Similarly, broad money growth, as measured by M2 excluding financial sector deposits**, fell to 10.3% in June but has retraced less than half of its rise between mid-2015 and late 2016 – third chart.


The transmission of slower money expansion to prices rather than activity is highlighted by producer price / industrial output data. Six-month PPI inflation eased from 5.8% in February to 0.7% in June, while six-month industrial output growth rose to 4.7% in June, a 42-month high – fourth chart.


A further monetary slowdown would raise the risk of economic damage but easing inflation and currency stability have allowed the PBoC to start reversing first-half policy tightening. Three-month SHIBOR has fallen back to its April level, although seasonal factors may also have played a role – fifth chart.


A constructive economic view will be maintained here barring a further decline in money growth. External risks may be more significant – a change in US trade policy and / or a strong rebound US economic growth later in 2017, resulting in upward pressure on US rates / the dollar and a reacceleration of Chinese capital outflows.

*True M1 = currency in circulation plus corporate / household demand deposits. The official M1 measure includes only corporate deposits.
**Financial sector deposits are volatile and contain little information about future spending on goods and services. Such deposits surged in 2014-15 but have stagnated in 2016-17, i.e. they gave a significant boost to M2 growth in 2014-15 but are now exerting a drag.