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Inflation Rises Faster than Expected in December, Heralding an Acceleration in 2021

Inflation rises

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UK inflation rose again in December and surpassed the expectations of market participants, but the rises are not yet significant enough to suggest there is any reason for the Bank of England to shift course on interest rates or other monetary policy settings.

As such, the initial reaction by Pound Sterling to the figures is subdued.

According to the Office for National Statistics (ONS), the UK inflation rate rose 0.60% Year-on-Year (YoY) in December, which is faster than the reading of 0.30% recorded in November and is faster than the 0.50% expected by the market.

Prices rose 0.50% on a Month-on-Month (MoM) basis, which is greater than November's 0.30% rise and faster than the consensus forecast for a reading of 0.50%.

Inflation rises in UK

Above: CPIH and CPI 12-month inflation rates rose between November and December 2020. CPIH, OOH component and CPI 12-month inflation rates for the last 10 years, UK, December 2010 to December 2020.

Core inflation - which strips out impacts such as fuel fluctuations - rose by 1.40%, which is quicker than the 1.1% recorded in November and the consensus forecast for a reading of 1.30%. Core inflation was flat in December on a MoM basis, but this is still a rise on the -0.10% recorded in November.

Driving December's price rises were:

- higher prices in recreation and culture
- rising IT equipment and computer game prices.
- transport inflation which jumped as air fares were hiked
- a rise in clothing prices which rose from -3.6% to -1.8%

"Inflation will probably start to rise more sharply from April when the temporary VAT cut for the hospitality sector is reversed and the recent rises in agricultural and energy commodities start to make themselves felt. Together these forces could lift inflation to more than 2% by the end of the year," says Thomas Pugh, UK Economist at Capital Economics.

The data had little impact on the value of Pound Sterling as the figures did not provide enough of a surprise to shift market expectations with regards to future Bank of England Monetary Policy.

The Bank would only likely raise interest rates and withdraw its quantitative easing programme in the event that inflation was at risk of overshooting their 2.0% target for inflation in a sustainable and significant manner.

What drove inflation price rises in December

Above: Rising transport costs and clothing and recreation prices pushed up the CPIH inflation rate. Contributions to change in the CPIH 12-month inflation rate, UK, between November 2020 and December 2020. Source: Office for National Statistics – Consumer price inflation.

By lowering or raising interest rates the Bank can help influence inflation, with lower rates traditionally expected to stimulate economic activity and inflation, while higher rates are typically expected to restrict the flow of money in the economy and cool both economic growth and inflation.

If anything, markets continue to expect the Bank to cut interest rates at some point between mid-year and year-end.

But should inflation rise again in coming months this expectation could be reduced as investors raise bets that the Bank risks stoking further inflation by lowering interest rates even further. Such a development would tend to benefit Sterling which traditionally finds itself better supported when foreign investors send money into the UK to take advantage of the high yields on offer in a higher rate environment.

The rise in inflation seen today could however be a harbinger of faster-than-expected prices over coming months, particularly if the UK economy can shake of the yoke of covid-19.

A strong economic recovery combined with low interest rates and the stockpiling of cash in consumer bank accounts could yet all combine to deliver a strong inflationary impulse.

"As pandemic fears wane, we expect households to further pare down savings and companies to resume investments. Meanwhile, we see low risk of policymakers unwinding extremely stimulative fiscal and monetary policies till job markets have recovered significantly and the market’s inflation expectations have risen sustainably above central banks’ 2% target," says an economic briefing note from Standard Chartered.

Added to the prospect for greater demand by consumers is the potential for supply-side disruptions, which might only intensify inflationary pressures.

"While today’s reading was not particularly notable, we are going to be talking a lot more about inflation in 2021 than we did 2020. Both Brexit and Covid-19 are factors that have caused substantial pain for businesses and their supply chains. Rising prices as demand works against supply constraints is already being seen in certain imports courtesy of the goods themselves and the shipping containers that they travel round the world in," says Jeremy Thomson-Cook, Chief Economist at Equals Money.

"We expect these increases will begin to be seen in the next couple of months as cash-strapped businesses with little margin to play with have to raise prices on customers," adds Thomson-Cook.

Such a development would likely pile pressure on the Bank of England to raise interest rates.