Inflation heading close to zero - Capital Economics
UK Economics

Inflation heading close to zero

UK Economics Update
Written by Ruth Gregory

The collapse in economic activity, spike in unemployment and slump in oil prices look set to push inflation down from 1.7% now to around 0.5%, with the risk that inflation falls to, or below zero. Either way, if activity and oil prices recover in late-2020 as we expect, a persistent bout of deflation is unlikely.

  • The collapse in economic activity, spike in unemployment and slump in oil prices look set to push inflation down from 1.7% now to around 0.5%, with the risk that inflation falls to, or below zero. Either way, if activity and oil prices recover in late-2020 as we expect, a persistent bout of deflation is unlikely.
  • While the global financial crisis was mainly a shock to demand, the coronavirus crisis is affecting both demand and supply, meaning that the risks to the inflation outlook are not all in the one direction. The shock to demand as households and businesses spend less is deflationary. But the supply shock is inflationary, given that there are fewer goods and services to meet a given amount of demand. Some have argued that the huge increases in government spending and the increase in quantitative easing (QE) by the Bank of England will boost inflation down the line too.
  • However, we suspect that the disinflationary effects of the demand shock will dwarf any upward pressure for four key reasons. First, the experience over the past decade shows that even big rises in the government deficit and QE haven’t stoked price pressures by much.
  • Second, while panic buying may have pushed up prices for some goods, such as tinned food and hand sanitiser, the closure of non-essential businesses means that demand has slumped for most other goods and services. In particular, prices could fall sharply for package holidays, accommodation, flight tickets, furniture, clothing, household appliances and cars.
  • Third, while the near-10% drop in the sterling trade-weighted index over the past month might in normal times prompt a 1.2ppts rise in CPI inflation in 2020, we do not expect sterling’s fall to last. (See here.) Even if the pound does stay lower for longer, this won’t mechanically boost inflation like it did after the 2016 EU referendum. Against the background of the unprecedented slump in demand, producers and retailers will surely absorb most of the rise in their costs into their margins. As such, we have assumed that only 40% of sterling’s fall feeds through to higher prices this year, bolstering inflation by about 0.5 percentage points (ppts).
  • Fourth, the 0.6ppt downward effect from the precipitous drop in oil prices and the 0.4ppts from pre-announced cuts to households’ utility bills means it will be very difficult for inflation to remain above 1% this year. Bringing all this together, we now think that CPI inflation will fall from 1.7% in February to a low of about 0.5% in August and stay there until the middle of 2021. (See Chart 1.) The initial fall will mostly be due to the more immediate energy effects. But as the hit to demand starts to come through later in the year, core inflation will drop from 1.6% in February to about 1% by the start of 2021. (See Chart 2.) Both CPI and core inflation are roughly 0.5ppts lower than we had previously thought by the end of 2021.
  • Overall, as the economy heads into recession (see here), disinflationary pressure is likely to be rife. While we are not currently expecting another bout of deflation, we do think that inflation will head close to zero and remain well below target next year. If anything, inflation could be lower than we expect. This means that even by 2021, there may be little pressure on the Bank of England to raise interest rates from the current all-time low of 0.10%.

Chart 1: CPI Inflation (%)

Chart 2: Core CPI Inflation (%)

Sources: Refinitiv, Capital Economics

Sources: Refinitiv, Capital Economics


Ruth Gregory, Senior UK Economist, +44 7747 466 451, ruth.gregory@capitaleconomics.com