Unexpected UK inflation drop fuels stimulus hopes

Consumer price inflation in Britain eased to 2.8% in May, an improvement which caught the market by surprise

15:04 June 21, 2012

London: Consumer price inflation in Britain eased to 2.8 per cent in May, an improvement which caught the market by surprise and raised expectations that the Bank of England will provide more stimulus to the economy within weeks.

A 3.1 per cent drop in the price for motor fuel, as well as a slower increase in the cost of food and non-alcoholic drinks, was the key driver in pushing the year-on-year rate down from 3 per cent in April, the Office for National Statistics said Tuesday.

It is the first time that the benchmark rate has been below 3 per cent since December 2009, though it is still above the official target of 2 percent. The market consensus was that the inflation rate would be unchanged in May. The consumer price inflation rate has fallen sharply since peaking at 5.2 per cent in September as the economy has dropped back into a mild recession, following consecutive quarters of negative growth in the fourth quarter of last year and the first quarter of 2012.

The drop in inflation will add to expectations that the Bank of England will sanction a new round of monetary stimulus. High inflation had in the past prevented it from doing so, as stimulus measures tend to boost consumer prices, while the central bank is tasked with keeping inflation close to 2 per cent.

The Bank of England has pumped £325 billion ($509 billion) into the economy since March 2009 through quantitative easing, the purchases of high-quality assets including government securities from banks. Bank of England Governor Mervyn King said last week that "the case for a further monetary easing is growing."

"With the economic data suggesting the UK is set for another quarter of economic decline in the current quarter, with even the previously strong-looking business surveys now turning down, the odds have certainly increased that the Bank of England's Monetary Policy Committee will vote for more quantitative easing at its July meeting," said Chris Williamson, chief economist at financial data company Markit.

Chris Crowe, analyst at Barclays Capital, said he expected the bank to authorize a further £50 billion in July.

Meanwhile, the Bank of England will launch a new liquidity program on Tuesday to ease concerns that financial turmoil in the nearby eurozone could create a credit crunch in Britain. The Extended Collateral Term Repo Facility will provide cheaper funding against a wider variety of assets for commercial banks via loans from the Bank of England. The hope is it will encourage banks to lend more to businesses and individuals. The Bank plans to allocate at least 5 billion pounds in the form of short-term loans every month.

"The question is how successful the schemes will be. The answer depends on whether these businesses and households are confident enough to want to borrow in the current uncertain climate," said Andrew McLaughlin, chief economist at Royal Bank of Scotland.