Gas, inflation and the Bank's MPC

  • 8 June 2011
  • From the section Business
  • comments
Mervyn King looking down facing a sign saying inflation
The Governor of the Bank of England, Mervyn King, must decide whether to raise rates to tackle inflation.

This week's price hikes by Scottish power shows the Governor of the Bank of England had one thing right in his press conference last month: forecasting energy price rises really is a mug's game.

The Bank's latest inflation forecast is built on the expectation that the price of domestic electricity will rise by 10% over the next nine months and gas by 15%. But already this Spanish-owned utility company, with 2.4 million customers in the UK, is raising the price of domestic gas by 19% and electricity by 10%. For the average customer, that could add £175 to their annual bill. Scottish Power prices are already above the industry average, so the betting now is that the other "big six" utility companies will follow suit.

Does that mean that inflation will go even higher than we thought? Economists at Barclays Capital think so; they've just released a revised inflation forecast for the UK in direct response to the Scottish Power announcement (see chart below). This has CPI inflation peaking at 5.2% in October, with RPI going as high as 6.4%.

Overall, Barclays have raised their inflation forecast by about 0.4 percentage points from November 2011 until August 2012. This is based on an assumption that gas prices will now rise by 20% between August and the end of the year, and electricity by 10%. But that is a big change from Barclays' previous forecast that home energy bills would go up by 6% this autumn.

A graph showing Barclays capital inflation expectations

Will any of this make a material difference to the MPC? Probably not. As we've seen, the Bank was already expecting a pretty big rise in home energy prices. Mechanically, raising the gas price forecast from 15% to 20% only adds about 0.1% to the headline CPI rate.

More to the point, gas prices are only one of many forces acting on inflation - and, as any retailer will gloomily tell you, many of those forces are likely to pull inflation down. Today's BRC-Nielsen shop price index - based on an industry survey rather than official figures - shows non-food prices rising at an annual rate of just 0.8% in the year to May, down from 1.2% in April.

The MPC will want to see more data before drawing a strong conclusion about the state of retail spending; recent surveys have painted a mixed picture. But if the latest national accounts data are accurate, real household spending fell by 0.6% in the first three months of 2011 and was actually 0.3% lower than in the first quarter of 2010.

As the FT pointed out recently, households could be looking at the slowest recovery since records began in 1830, at least in terms of growth in consumer spending. And that's if everything follows the OBR's forecast, which many now consider optimistic, including the European Commission, in its UK recommendations published yesterday.

The MPC believes there will be at least one silver lining to that cloud: falling inflation from 2012 onwards. But as the IMF pointed out in their gloomy endorsement of the UK's policies on Monday, there is another possibility: that spending and growth will be persistently weak over the next few years, but inflation will remain stubbornly high. In that case, the Bank and the chancellor would both have much bigger problems to deal with than higher energy bills.