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Falling inflation, rising real wages and consumers on a high

The second estimate of GDP remained unchanged suggesting the economy grew by 0.5% in the fourth quarter of 2014 compared with the previous quarter. Consequently annual growth for the UK remained at 2.6% which rounded off an impressive year - the fastest growth of any G7 economy. We forecast the UK economy to grow by 2.5-3.0% in 2015.

Household consumption provided the greatest contribution in the final quarter - 0.3 percentage points of the 0.5% rise in GDP. We believe Goldilocks conditions of low inflation robust wage growth improving consumer confidence and stronger macroeconomic fundamentals will underpin consumer spending to rise at an annual rate of c.3.0-3.5% this year. Indeed households incomes rose by 1.2% on the quarter outpacing nominal spending of 1.0% - meaning the recovery is no longer being supported by households saving less.

More detailed data showed that the recovery has become more balanced with net trade finally playing a role in overall growth. The 3.5% rise in exports greatly exceeded the 1.3% rise in imports. However to put into context exports in 2014 as a whole were only 0.4% higher than in 2013 so we mustnt get too carried away with the much-anticipated rebalancing of the economy. But against a backdrop of the strength of the pound and weakness in the euro-zone these figures offer some confidence that they not intractable obstacles.

Low inflation rising real wages will support consumer spending

'Deflation' is the word of the moment and Januarys record-low CPI of 0.3% shows that inflation is on the verge of turning negative. We expect inflation to continue to fall through the first half of 2015 as the impact of weaker oil prices feed through the supply chain. We believe the risk of deflation becoming entrenched is low given that many of the downward pressures are temporary and one-off in nature. Over the course of the year the effect of these influences will diminish leaving inflation to edge back up. The Bank of Englands latest report suggests that the inflation target of 2% will not be hit until 2017.

Chart 1

Source ONS

However the Bank of England has stated its intentions to look through the immediate effect of the fall in oil prices to broader economic forces like wages and productivity when contemplating a rise in interest rates. Interestingly the latest Monetary Policy Committee MPC minutes revealed there is a wider difference of opinion than a unanimous vote to keep interest rates on hold would suggest. On the one hand some members are suggesting there could be a rise in interest rates before the end of the year while others suggest loosening of monetary policy is just as likely as tightening. In a departure from previous policy options Carney made it clear that he would be willing to cut rates further should deflation show signs of becoming entrenched. However given the strong economic outlook we dont believe this to be a likely policy option. Ultimately the data will dictate the course of action in the coming months but we believe it is pretty clear the next move will be a rate rise. The question remains when Market expectations have shortened a little but we believe the first half of 2016 the most likely scenario for the first rate rise.

The outlook for the labour market and wages will be critical in swaying thinking on monetary policy. On that front the latest data showed annual growth of average weekly earnings accelerating from 1.9% in November to 2.4% in December far higher than inflation of 0.3%. Real wage growth is likely to gather pace in the coming months as inflation turns negative and nominal wage growth accelerates as the labour market tightens chart 2. The unemployment rate fell further to 5.7% in December from 5.8% in November while the claimant count fell by 38600 in January alone.

Importantly wage rises do not appear to be tailing-off and the latest IDS settlement figures show that median pay has picked up to around 2.5%. It would be a concern if businesses saw a period of deflation as an opportunity to award lower pay increases however after five years of persistent low wage rises we do not believe this to be the most likely outcome. Indeed the Bank of Englands forecasts suggest wages could be rising at a rate of 3.5% by the end of 2015.

Chart 2

Source ONS

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