Fundamental Update: What to expect in the UK’s Inflation Report

In its November 2011 Report, the Bank's analysis made for grim reading. It said that the prospects for the UK economy had worsened due to fiscal consolidation at home and stresses in the Eurozone. The Bank sounded concerned about growth, which had expanded well below its historical average in 2011. It expected a "near-term" slowdown in economic expansion, followed by a recovery in Q2 and Q3. However, it added that the "outlook for output growth is unusually uncertain".

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The Bank also expected inflation to fall sharply in 2012 due to the decline in VAT, energy and import price contributions to the price index along with downward pressure from slack in the labour market. The Bank acknowledged that there were a range of views about the out-turn for inflation within the Committee and again that the outlook was uncertain. However, it said that on balance the Committee felt inflation was likely to be below the 2% target in the coming 2 years than above it.

So what could this report hold?

The latest inflation data from January showed a sharp decline in both the headline CPI rate and the RPI rate. The RPI rate fell to its lowest level since August 2010, while the CPI rate has fallen by 1.6% since peaking at 5.2% in September 2011. This decline has been due to VAT falling out of the index and the declining cost of commodities including food, alcohol and tobacco products. Thus, inflation looks like it is following the Bank's projected path in its November Report and tomorrow we expect inflation estimates to continue to point to an under-shoot in the inflation target next year.

However, the one area that differs from the Bank's prior projections is growth. The "recovery" in growth has been much quicker than expected. The PMI manufacturing survey was stronger than expected, along with the services survey, which reached its highest level in nearly a year. Industrial production and trade data also picked up at the end of 20111.

Although the Bank expected the decline in output to be temporary, the better tone to the economic data in recent weeks may be enough for the Bank to bring forward its recovery period to the first quarter of this year and tomorrow we may see some upward revisions to its projection for growth.

However, the big problem is unemployment. The latest jobless rate is released tomorrow also and it is expected to show that the unemployment rate will remain at a lofty 8.4%, the highest level since 1995. Added to that, an extra 3,000 people are expected to have claimed unemployment benefit in January. Combined with fiscal tightening (the bulk of public sector spending cuts are expected in the next 2 parliamentary years) along with continued risks from the Eurozone and the Bank may want to urge on the side of caution.

To QE or not to QE?

Last week the pound and Gilt yields rose when the Bank announced its latest increase in asset purchases. That may have been because the Bank "only" pledged to buy another GBP 50 billion, below some expectations of GBP 75 billion. So because the Bank scaled back on its asset purchases there won't be any more, right? No.

In its first round of QE back in 2009 the Bank bought GBP200bn of assets at GBP50 billion clips and then finished it off with a GBP25 billion pledge at the end of October 2009. So GBP 50 billion tends to be the standard amount of purchases for the Bank, and the October 2011 GBP 75bn of increase to the asset purchase target was the anomaly. Back then financial markets were in a tizzy about a meltdown of the Eurozone as the sovereign debt crisis spiralled out of control, now that things have stabilized post the ECB's LTRO programme the Bank can go back to the smaller increments it is used to.