Inflation has been stubbornly low across major economies, struggling to hit Central Banks’ 2% target. Data released this week confirmed this trend yet again.
In the US core Personal Consumption Expenditures (PCE) the Federal Reserve’s preferred measure of inflation, improved slightly to 1.4% in October, but remained firmly in a 1.3 – 1.5% range seen in recent years. In Europe core inflation fell more than anticipated to 0.9% from 1.1% in September. Policy makers attribute such low inflation to “transitory” and “idiosyncratic” factors. It is getting more difficult to accept this explanation given how long this transitory period has lasted and the fact that it occurred with the backdrop of decent economic growth. What if this low level of inflation is structural? Is 2% the right target? It probably was in the past, at times when productivity and growth were much higher, but it could be argued that in current conditions a lower target is more appropriate.
The UK stands out among major economies as its inflation sits at a five-year high. However, this has been mostly driven by past currency depreciation and there are definite signs that this effect is now fading. October Consumer Price Inflation was unchanged versus the previous month at 3.0%. Although it was a whole 1% above a “fits all” target, it fell below the consensus estimate (3.1%) and Bank of England’s own projection (3.2%). Domestically generated inflation continued to be soft, particularly in the service sector, with rent and education being key detractors (rent inflation was the slowest since records began 20 years ago). Other economic indicators were uninspiring as well. Wage data failed to show any sign of a pickup, while the number of people in work fell for the first time in almost a year. Not surprisingly, retail sales dropped 0.3% year on year in October, posting the first decline in more than four years.
The UK’s Monetary Policy Committee finds itself facing a tough choice. They have already delivered a rate hike last month, and projections are they will do more next year. Monetary policy tightening at this juncture can hardly be justified by stronger economic activity. The only possible explanation is a fear that inflation will rise rapidly as a result of a major supply shock, which the UK economy could face as it goes through Brexit. If this scenario fails to materialise, the UK could very soon find itself joining a low inflation club as well as facing a decline in economic growth, triggered by Brexit and tighter monetary policy.