A new “monetarist” forecast for UK inflation – November 2021

A post a year ago presented a “monetarist” forecast that UK CPI inflation would rise to 3.2% by Q4 2021. The outturn will be significantly higher – projected here to be 4.5% – but the post at least anticipated current problems, unlike Bank of England and consensus forecasts at the time.

The pessimistic view was based on two considerations:

1) A surge in broad money during 2020 was expected to be reflected in upward pressure on “core” prices (i.e. excluding energy, food, VAT effects etc) during 2021-22.

2) An upswing in the global stockbuilding cycle was judged to have started and was expected to be associated, as usual, with a rise in energy and other industrial commodity prices. Global “excess” money, moreover, was likely to magnify this increase.

What does the same approach suggest now? As explained below, CPI inflation is projected to rise to a higher peak than expected by the Bank of England and consensus in H1 2022 but could return to target more quickly than implied by the Bank’s current forecast based on conventional energy price assumptions. The latter prospect, however, is conditional on a recent slowdown in money growth being sustained and no additional boost to inflation from exchange rate weakness – a significant risk given trade account deterioration and an overhang of overseas sterling balances at UK banks.

The six-month rate of change of core consumer prices, seasonally adjusted, surged from 0.6% (not annualised) in April 2021 to 2.3% in October. This mirrors a surge in six-month broad money growth between February and August 2020 – see chart 1.

The implied 14-month lead time is shorter than usual – the monetarist rule of thumb is that money stock changes precede price changes by about two years – and may reflect bottleneck / catch-up effects as the economy has reopened.

Six-month broad money growth has fallen significantly since August 2020, although the decline was held up by the MPC’s unwise further expansion of QE in November 2020. If the assumption of a 14-month lead is correct and this is maintained, the suggestion is that six-month core CPI momentum is peaking and will moderate through end-2022.

The projection for core CPI momentum in 2023 in the chart assumes that six-month broad money growth stabilises at its current level of 2.9%, or 5.9% annualised. This is above the pre-pandemic norm – annual growth averaged 4.5% over 2015-19 – and probably too high for core CPI inflation to return to 2% annualised or below; the projection assumes stabilisation at 2.25%.

A recent post discussed the global stockbuilding cycle and argued that the next low could occur in Q3 2023, based on the average length of the cycle. Industrial commodity prices typically fall in the 18 months leading up to a cycle low, on average retracing about half of their rise during the 18 months following a trough.

For the purposes of the forecast, the CPI energy index – which includes electricity / gas and vehicle fuels – is assumed to retrace about 40% of its increase between December 2019 and June 2022 by December 2023, with the decline occurring steadily over the latter period.

The electricity / gas index is assumed to rise by 26% in April 2022, in line with the Bank of England’s current projections for Ofgem tariff cap increases.

The final component of the forecast is an assumption about food price inflation, which remains low at an annual 1.3% in October but is projected to rise to 3.0% by December 2022. This could prove conservative, with producer output price inflation of food products now at 4.0% – chart 2.

Chart 3 shows forecasts for headline and core annual rates based on the above assumptions. CPI inflation peaks at 5.7% in April 2022 but a retracement of energy prices results in it falling slightly below 2% by Q2 2023. For comparison, inflation is 2.6% in Q2 2023 in the Bank’s conventional forecast, with a convergence to target delayed until a year later.

The possibility of an earlier return to target does not, of course, vindicate the MPC’s reckless decision to ease policy into a supply shock and double down with more QE in late 2020 despite an inflationary warning from monetary trends. On the forecast here, the level of the CPI in Q4 2022 will be 2.8% higher than projected by the Bank in November 2019, representing a 2.6% overshoot of the inflation target over this period.