Concerns that inflation is about to take off appear unjustified

The fall in the value of the pound after the vote for Brexit pushed up the cost of imports and then domestic prices in the UK. As a result, the Consumer Prices Index (CPI) has been hovering around 3% for the past few months. Yet the sterling effect will fade away from the annual calculations soon and the inflation rate is likely to drop to around 2.5% by the middle of 2018, according to our estimates.

Around the rest of the world, inflation has remained subdued. Prices are rising at an annual rate of more than 2% in just over 30% of the 35 countries in the Organisation for Economic Co-operation and Development (OECD). Typically, the proportion of countries is around 60%. Notably, the six-month change in the annual rate of inflation is falling in many countries.

In the US, jobs and wage growth have been stronger than expected recently, raising concerns that inflation could be about to pick up. The stock market suffered a brutal sell-off in February because investors worried that the improving economy would prompt the Fed to ramp up interest rates faster than previously thought.

Concerns that inflation could accelerate have been compounded by President Donald Trump’s announcement of tariffs and the prospect of a global trade war. China and the EU both warned that they will retaliate, with incalculable consequences for the world economy.

Yet, excluding food, energy and housing, core inflation in the US is almost as low now as it has ever been. The services component of the US CPI measure, which reflects domestic inflation pressures more accurately, is still well below the pre-crisis average. Notably, the correlation between wages and inflation has been weak for some time, and we believe the market has probably over-reacted to recent data (figure 3).

China’s producer price inflation is coming back down, although this could influence energy and food inflation more than core goods and services in the West. 

Figure 3: A weak relationship

^{The correlation between wages and inflation in the US is very weak, which is an unusual situation but not unprecedented.}

^{_{Source: Datastream and Rathbones.}}

Oil and the global economy

The cost of a barrel of oil can have a big impact on global inflation rates because it is the world’s most-traded commodity. Brent crude prices (a popular benchmark) have fallen slightly from a peak in January to below $70 despite ongoing agreements by members of the Organization of the Petroleum Exporting Countries (OPEC) to control production.

US shale producers have contributed to the situation by increasing output. According to the International Energy Agency, America could soon overtake Saudi Arabia and Russia to become the world’s biggest oil producer. Yet recent reports suggest growth has slowed and it appears unlikely that a new glut of shale oil will cause prices to fall sharply. As a result, oil prices are likely to have a limited impact on global inflation throughout 2018.

With the global economy enjoying synchronised economic growth, one aspect puzzling economists is the ongoing combination of surprisingly low inflation and low unemployment. Possible reasons include the growth of the digital economy and the spread of automation across many industries. Low productivity growth is another cause for concern and some are asking whether digital distractions and the demographic shift in the workforce are to blame.

As we noted in our recent research report Under Pressure?, some of the structural forces acting on inflation are changing in interesting ways. But we’re not expecting a sharp rise or fall in inflation in the coming year, nor does the balance of evidence suggest a profoundly inflationary or deflationary environment will unfold in the long run either.