Schroders: UK inflation falls sharply

Compared to just six months earlier where inflation was a healthy 1.9%, the fall has been dramatic and it takes the CPI rate to its lowest level since May 2000 – even lower than the deflationary period during the financial crisis. The fall is clearly being driven by the sharp drop in global energy prices. When energy, food and alcoholic beverages are excluded, the core rate of inflation actually rose from 1.2% to 1.3%.

Households yet to feel energy price drop

Within the details of the latest inflation data release, housing and household services - specifically home energy inflation - was the biggest downward contributor. Home energy inflation was unchanged in December compared to 6.5% and 6.7% increases in electricity and gas bills respectively a year earlier. Interestingly, despite the sharp fall in wholesale energy prices, the savings have not been passed on to households – prompting calls from a number of politicians for a review of the market. We expect savings to be passed on in the next few months, which would lower inflation further.

Another area falling global energy prices are affecting is transport fuel, where the average price of petrol has sunk from £1.31 per litre in July to £1.11 pence per litre last week. Based on our analysis of the relationship with oil prices, we expect the price of petrol to drop by 8 pence per litre in the coming months.

Monetary policy outlook

Overall, whilst the low headline inflation rate would ordinarily be seen as a sign of weakness in the economy, the external shock of low oil prices is likely to boost the disposable income of households, encourage greater spending, and raise economic growth for 2015. As a result, we do not expect the Bank of England to consider easing monetary policy at all in the near future. As global oil prices stabilise, we expect inflation to rise again next year, with the impact of recent falls falling out of the annual comparison. Therefore, the Bank could still consider raising interest rates this year, particularly if we see another year of strong growth – now more likely thanks to falling oil prices.