CPI and Inflation Expectations

I thought I’d return to the subject of CPI – Consumer Price Index – in the UK, seeing as we know that this is what the BoE is now using to track Inflation and therefore forecast Inflation Expectations.

I flagged this on Twitter last month, and commented on the Eurozone challenge (I’ve also compiled a quick video to explain it as well), but let’s explain it in a bit more detail for you and why Mr Carney has a delicate challenge on his hands (although not as big as the ECB).

So here is a nice chart from my Reuters terminal:

CPI

As I am hoping you can all see, we are in ‘disinflation’ at the moment, which is the lowering of inflation (orange line is actual, blue line is estimate. Note, not only is the orange line going lower, which is disinflation, but it is also below expectations)

What this means is that the price of goods and services are becoming less, meaning the money in your pocket can typically buy more. The general theme of the current run of disinflation has been closely linked to the fall in oil prices.

In general terms, in a recovery you want people to spend more, so having goods and services cost less is fantastic. Right? Yep it is, and Mr Carney would love a low inflation rate – as long as it is positive – as it will help the UK economy.

But what Mr Carney definitely doesn’t want is deflation and, more critically, long run deflation, which is where we could easily be heading and is likely to become a major topic for the election (what government makes difficult decisions in a run up to a election?).

Now the key difference here is deflation typically leads (in most economists opinions) to a deflationary spiral. This typically goes like this:

Lower prices lead to lower demand, lower demand leads to lower production, lower production leads to lower wages, lower wages leads to lower income, lower income means less spending, less spending means lower prices…

And we all end up with less money and in a bit of a mess.

The caveat here is that actually there are lots of schools of thoughts here, but let’s go with this for now: this is what we are seeing in the Eurozone in some areas.

So what can the BoE do to ensure we stick with low inflation and not deflation?

The overall principle is that you need to stimulate the economy and get money flowing.

To do this you either need to stimulate business so that wages increase, thus people have more to spend and therefore prices start to climb on a stimulated economy following economic growth, or you need to reduce people’s debt, thus increasing the real money in their pockets so they can spend more: increasing growth thus stimulating the economy.

Well this is where it becomes tricky, and you get into some grey areas, as it depends on what thought process you follow.

Typically, in normal economic conditions (i.e. inflation above target 2%) you would lower interest rates to stimulate money flow by reducing everyone’s debt, but obviously that is a little tricky as what good would lowering interests do when they are so low? As we have seen, part of the challenge at the moment is that banks won’t pass on that reduced interest rate to borrowers, but pass it on to savers: thus people’s debt is not less, but their savings are, well… eek.

One option is that we could do more QE in the hope to spur more money into the economy, get businesses investing, thus raising wages and providing more money for people to spend.

But I’m not actually sure that there is an appetite for that, and the market doesn’t really view lots of QE as effective, so the likely impact on UK currency would be a drastic devaluation (is that good if we import more than we export?).

So what about Carney?

Well I’m inclined to believe, given his BBC and ITV interviews, that he thinks we will get low inflation for a little while, possibly minor deflation but which will then recover. And if not? They can step in.

Now obviously the Inflation rate is a sliding scale but this isn’t how the markets will react. The key here is what this means for rate rises and potential further monetary action in the UK.

So if you take the premise, as we explain in our Forex Trading Course, that rate rises equal stronger economy therefore stronger GBP.

This leads to two conclusions, the rate rises are potentially further delayed this year, meaning we might not even see them this year if inflation stays low. It also means that if we get into a deflationary territory like we see in Europe, Carney might not have any other choice bar additional QE, which would be very negative to the UK as mentioned above.

So at the start of the year (2015), most were expecting UK rate rises, all be it small of 0.25% or 0.5% increase, either half way through the year or towards year end. These expectations have now already been pushed out past year end and some are even pricing in rate cuts.

This could make the year on year CPI measure a critical indicator to watch this year, if that chart starts going negative…well that isn’t going to be pretty and rates cuts and even QE might start to get priced in (thus watch the GBP tumble)

The additional challenge they have is that we have elections this year.

Whatever plans any government had, if we are in a deflationary environment they need to ensure that it doesn’t last long enough for that spiral to take hold. Otherwise this recovery will be a long drawn out double-dip recession and, well, it’s going to be another 10 years before any real sustained growth.

The good thing for Carney and the Chancellor though, is that at the moment job growth is still there and we do seem to have growing economy (GDP). It’s not going to take much to end that run though.

So, fragile times for the UK.

What makes this interesting is that inflation as measured by Consumer Price Index will have taken a hit from Oil and more recently Tesco entering into supermarket price wars to attempt a major recovery.

Remember Consumer Price Index is made from a basket of goods which includes Oil and supermarket items.

If Oil stays low (the UK’s main export) and Tesco steps up its price war to get itself back on a level footing, CPI is going lower.

Interestingly, this is where economists could find a new normal. Maybe the deflationary spiral won’t take hold and actually lower prices is exactly what the UK needs right now.
If business can see past the headlines then actually this could be a really good time for really low inflation or even deflation.

I do wonder how much the market and businesses will read into the shock headline ‘deflation’ when it comes, rather than the actual economics behind it.

Conversely as well, countering this with the US where you can see real sustained growth, it’s no wonder most are looking to US equities / markets for investment opportunities.
Is this therefore a time to short GBPSUD? Well that depends on your trading strategy.

But the COT report, our Order Flow and Psych Indicators have all been pointing the way lower on that pair for a long time, along with lots of other pairs. When companies don’t like your currency, it is a strong sign of what is happening.

One thing is certain though, 2015 is going to be really fun to be a currency trader as you are on the frontline of the global economic picture to view what unfolds.

Not only that, but there is a high chance for some amazing trends this year and you guys, having listened to me talk about trend trading, and ensuring you aren’t picking tops and bottoms and you follow the flow, are in prime position to capture a lot of pips.

Like the cut of Sam’s jib? Why not try our Forex Trading Course, written by Sam and the team here at Littlefish FX, and including all our recommended Forex trading strategies, plans and indicators to turn you from market minnow into trading shark. Find out more here.