UK retail sales in Q1 likely contracted from Q4 2016, despite their rebound in February. Falling real wages and slowing household borrowing are likely to further dampen retail sales and consumption growth going forward. The still large pool of available workers is seemingly limiting their wage-bargaining power, with nominal wage growth falling behind rising inflation. Moreover, investment growth is still only making a negligible contribution to GDP growth ahead of the British government’s decision to trigger Article 50 on 29th March. Much of the rise in inflation in recent months is attributable to imported inflation driven by Sterling’s depreciation since November 2015 with little evidence of demand-led inflation. This situation is reminiscent of 2007-2008 when Sterling’s collapse fuelled imported and in turn headline inflation. Should Sterling remain broadly unchanged going forward, its year-on-year pace of depreciation, currently around 9%, would slow from June onwards and hit zero towards end-year according to my estimates, in turn dampening imported inflation. I would expect retailers to stabilise prices to maintain market share in the face of tepid demand and for wage-inflation expectations to remain modest. This was certainly the case in the 12 months to September 2009 with CPI-inflation falling from 5.2% yoy to 1.1% yoy. The question is whether the BoE is willing to look beyond a potentially temporary rise in UK inflation – as Governor Mark Carney suggested – or whether it tries to short-circuit any self-reinforcing rise in prices. My base-line scenario is that the BoE will look beyond the current rise in UK inflation, unless at least one of three conditions materialise: (1) Nominal wage growth accelerates, comfortably outstripping headline inflation and driving consumption growth; (2) Commercial bank lending picks up significantly; and (3) Sterling depreciates materially from current levels, exacerbating imported and in turn headline inflation. I expect that neither (1) or (2) will materialise any time soon and that while risks to Sterling are probably to the downside, Sterling is unlikely to weaken sufficiently to push the BoE into hiking. I would however expect it to keep a possible rate hike firmly on the table.

1. 1
Bank of England and inflation – Sense of déjà-vu?
UK retail sales in Q1 likely contracted from Q4 2016, despite their rebound in February.
Falling real wages and slowing household borrowing are likely to further dampen retail
sales and consumption growth going forward.
The still large pool of available workers is seemingly limiting their wage-bargaining power,
with nominal wage growth falling behind rising inflation.
Moreover, investment growth is still only making a negligible contribution to GDP growth
ahead of the British government’s decision to trigger Article 50 on 29th March.
Much of the rise in inflation in recent months is attributable to imported inflation driven by
Sterling’s depreciation since November 2015 with little evidence of demand-led inflation.
This situation is reminiscent of 2007-2008 when Sterling’s collapse fuelled imported and in
turn headline inflation.
Should Sterling remain broadly unchanged going forward, its year-on-year pace of
depreciation, currently around 10%, would slow from June onwards and hit zero towards
end-year according to my estimates, in turn dampening imported inflation.
I would expect retailers to stabilise prices to maintain market share in the face of tepid
demand and for wage-inflation expectations to remain modest. This was certainly the case
in the 12 months to September 2009 with CPI-inflation falling from 5.2% yoy to 1.1% yoy.
The question is whether the BoE is willing to look beyond a potentially temporary rise in
UK inflation – as Governor Mark Carney suggested – or whether it tries to short-circuit any
self-reinforcing rise in prices.
My base-line scenario is that the BoE will look beyond the current rise in UK inflation,
unless at least one of three conditions materialise:
(1) Nominal wage growth accelerates, comfortably outstripping headline inflation and
driving consumption growth;
(2) Commercial bank lending picks up significantly; and
(3) Sterling depreciates materially from current levels, exacerbating imported and in turn
headline inflation.
I expect that neither (1) or (2) will materialise any time soon and that while risks to Sterling
are probably to the downside, Sterling is unlikely to weaken sufficiently to push the BoE
into hiking. I would however expect it to keep a possible rate hike firmly on the table.

2. 2
Falling real wages and soft retail sales do not bode well for consumption or GDP growth
The tragic events in London on Wednesday, which British authorities are qualifying as a terrorist attack,
continue to dominate the headlines. Understandably, financial markets may for now relegate to second
place UK macro data, including Office of National Statistics (ONS) figures for February retail sales released
yesterday.
The total volume of retail sales (including automobile fuel) rebounded 1.4% month-on-month in February
after having fallen consecutively in the previous three months albeit from an all-time high in October 2016
(see Figure 1). However, the volume of retail sales was still down 1.2% in January-February from Q4 2016
when retail sales rose 1.2% quarter-on-quarter. I estimate that retail sales would have to rise about 2.9%
mom in March – the second fastest ever rate of growth (they rose 3.0% mom in December 2013) in order
for retail sales in Q1 2017 to match the level of sales in Q4 2017 and thus for quarter-on-quarter growth to
be zero. March data are due for release on 21st
April, according to the ONS.
Figure 1: Retail sales rebounded in February after 3 months of contraction but Q1 still on course to be weak
Source: Office of National Statistics
Retail sales growth of near 3% yoy in March is very unlikely in my view. Real earnings have been falling in
recent months (see Figure 2) – a risk which I had flagged back in August (see UK economy post-
referendum - for richer but mostly for poorer, 26 August 2016) – and bank lending to individuals is slowing.
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Jun-13 Oct-13 Feb-14 Jun-14 Oct-14 Feb-15 Jun-15 Oct-15 Feb-16 Jun-16 Oct-16 Feb-17
Excluding automobile fuel sales Including automobile fuel sales
UK retail sales volume, seasonally adjusted, month-on-month % change

3. 3
Figure 2: Real weekly earnings in the UK were
down 1% in January 2017 from October 2016…
Figure 3: …as nominal earnings growth has failed
to keep up with higher inflation
Source: Office of National Statistics Source: Office of National Statistics
Note: * Including bonuses
The fall in real earnings is, in my view, in part due to a still large pool of available workers failing to
negotiate wage increases in line with rising CPI-inflation, as depicted in Figures 3 and 4 (see Market
Fatigue in the face of catastrophic success, 20 January 2017). Moreover, precedent suggests that
Wednesday’s terrorist attack may weigh on retail sales near-term (which includes the last week of March).
After the terrorist attacks in London on 7th
July 2005, retail sales contracted 0.1% mom in July and 0.9%
mom in August 2005.
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345
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Jan 12 Jan 13 Jan 14 Jan 15 Jan 16 Jan 17
Weekly earnings index including bonuses,
constant 2000 prices, seasonally adjusted
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Jan 12 Jan 13 Jan 14 Jan 15 Jan 16 Jan 17
Nominal weekly earnings, year-on-year %
change in 3-month moving average*
CPI-inflation, year-on-year % change

4. 4
Figure 4: Still large pool of available workersweighing on their ability to negotiate higher wages
Source: Office of National Statistics
Growth in non-secured bank lending to individuals (i.e. credit or non-mortgage lending) was reasonably
robust until mid-2016 but has since slowed and net lending has actually contracted in recent months (see
Figure 5). The ability and willingness of individuals and households to increase their bank borrowings has
seemingly hit a buffer for now, despite broadly stable interest rates on credit cards and the ongoing fall in
rates on other loans (see Figure 6). February lending data will be released on 29th
March (08.30 local time).
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Jan 03 Sep 04 May 06 Jan 08 Sep 09 May 11 Jan 13 Sep 14 May 16
Unemployed, part-time workers and economically inactive but want a job (millions)
Average (nominal) weekly earnings, including bonuses, % year-on-year (right scale, inverted)
UK pool of available labour and nominal weekly earnings

5. 5
Figure 5: Net credit to individuals has slowed
sharply in recent months…
Figure 6: …despite stable or falling borrowing
costs
Source: Bank of England
Note: Net lending is gross lending minus repayments
Source: Bank of England
In view of the above, it is more likely that retail sales will contract in Q1 2017 – the first quarter-on-quarter
contraction since Q4 2013 – and could remain soft in following months. Assuming retail sales are
unchanged in March, retail sales in Q1 2017 would be down 0.9% quarter-on-quarter – the largest
contraction since Q4 2010. Figure 7 shows a reasonably high correlation between UK retail sales and
consumption growth, despite household consumption also including services and purchases from abroad
while excluding tourists’ estimated expenditures. A contraction in retail sales would therefore point to soft
household consumption growth in Q1 2017.
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May-13 May-14 May-15 May-16
Quarter-on-quarter % change
£ billions (right scale)
Net unsecured lending to individuals
(3-month moving average)
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Jan 99 May 02 Sep 05 Jan 09 May 12 Sep 15
Other loans Credit cards
Average monthly interest rate on unsecured loans
to households, %

6. 6
Figure 7: A slowdown in retail sales growth would likely be a drag on overall household consumption growth
Source: Office of National Statistics
Given that household consumption accounts for over 60% of (real) GDP, a slowdown in household
consumption growth from 0.7% qoq in Q4 216 would in turn likely weigh on GDP growth which hit a 7-
quarter high of 0.7% qoq in Q4 (see Figure 8). At the same time, there is little evidence that fixed
investment is about to make a significant contribution to economic growth (see Figure 9), as I discussed in
UK inching towards Brexit (13 January 2017). Preliminary Q1 GDP data will be released on 28th
April but
will not include a demand-side breakdown which is to figure in the second estimate due out on 25th
May.
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1997 Q2 1999 Q3 2001 Q4 2004 Q1 2006 Q2 2008 Q3 2010 Q4 2013 Q1 2015 Q2
Household consumption
Retail sales (including auto fuel)
UK household consumption and retail sales, volume terms, quarter-on-quarter seasonally adjusted % change
Lastdata pointfor retail sales
is for Q1 2017 and assumes
thatretail sales unchanged in
March (from February)

7. 7
Figure 8: GDP growth resilient but downside risks
from possible slowdown in private consumption
Figure 9: Investment growth making little positive
contribution to GDP growth
Source: Office of National Statistics Source: Office of National Statistics
Sterling’s past depreciation driving imported and headline inflation but effects to fade
In a scenario of falling real earnings weighing on consumption, tepid investment growth and a
broadly stable currency, I would not expect the Bank of England (BoE) to hike its policy rate from
its record low of 0.25%. My core forecast is that rates will remain on hold throughout 2017.
The common counter-argument is that the BoE will have to hike its policy rate in order to counter rising
inflation. Headline CPI-inflation, which rose to 2.3% year-on-year in February (see Figure 3), has now
nudged past the central bank’s 2% target and core inflation, which strips out food and fuel prices, hit a 3-
year high of 2.0% yoy (see Figure 13). Monetary Policy Member (MPC) member Kristin Forbes went as far
as to vote in favour of a 25bp rate hike at the BoE’s 15th
March policy meeting, with the other 8 voting
members (including Governor Mark Carney) voting in favour of rates remaining on hold at 0.25%.
However, much of the rise in inflation is attributable to imported inflation driven by Sterling’s depreciation
since November 2015 and in particular since the UK referendum on EU membership on 23rd
June 2016.
There is indeed little evidence of demand-led inflation, with nominal wages and retail sales week in recent
months as discussed above.
Figure 10 shows that the rise in the imported price of goods in the UK since autumn 2015 has tracked the
pace of depreciation in the Sterling Nominal Effective Exchange Rate (NEER) – the weighted exchange
rate of Sterling against the currencies of the UK’s main trading partners. This is in line with the BoE’s
estimate that the pass-through from exchange rate movements to UK import prices is roughly 60% to 90%
and reasonably rapid.
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GDP Household consumption
Quarter-on-quarter % change, seasonally adjusted
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2014 Q4 2015 Q2 2015 Q4 2016 Q2 2016 Q4
Gross Fixed Capital Formation
Business Investment
Contribution to quarter-on-quarter GDP growth
(percentgage points)

8. 8
Figure 10: Sterling’s depreciation since autumn 2015 has pushed imported price inflation to multi-year highs
Source: Office of National Statistics, Bank of England, investing.com
This rise in imported inflation has in turn contributed to the rise in headline CPI-inflation. While the BoE
estimates that the pass-through from imported inflation to headline inflation is only 30% and can take years
to materialise (with other factors, such as international oil prices, driving prices), Figure 11 suggests that
this pass-through has been more immediate. There is indeed much anecdotal evidence of UK retailers
(including supermarkets and oil companies) passing on higher imported prices to consumers.
I would add that the speed and magnitude of this rise in imported prices are comparable to the rise in
imported prices in the 18 months to June 2008 triggered by the collapse in Sterling ahead of the great
financial crisis (see Figure 12). This rise in imported prices contributed to headline CPI-inflation rising from
below 2% yoy in summer 2007 to a multi-year high of 5.2% yoy in September 2008 (see Figure 11) while
core CPI-inflation rose from 1.2% yoy in February 2008 to 2.2% yoy in September 2008 (see Figure 13).
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Jun-11 Feb-12 Oct-12 Jun-13 Feb-14 Oct-14 Jun-15 Feb-16 Oct-16 Jun-17
Price of imported goods
Sterling Nominal Effective Exchange Rate, right scale (inverted)
Year-on-year % change
Assumes
unchanged
GBP NEER till
end -year

9. 9
Figure 11: Surge in imported prices sufficient to
drag headline inflation higher…like in 2008
Figure 12: If stability in Sterling NEER extends,
pace of imported inflation should abate
Source: Office of National Statistics Source: Bank of England
Should Sterling remain broadly unchanged going forward, its year-on-year pace of depreciation which has
already slowed sharply since last Autumn to around 10% would slow further from June onwards and hit
zero towards end-year according to my estimates (see Figure 10) – as a result of course of the higher
levels of the Sterling NEER falling out of the calculation. This would in turn help stabilise imported prices,
assuming no major change in international oil and food prices. Again, this would broadly replicate the
pattern recorded between mid-2008 and mid-2009 when the pace of imported inflation collapsed (see
Figure 11).
Whether retailers continue to increase their prices would of course depend on a number of factors and it is
conceivable that retailers will be slower in stabilising prices than they have been in raising them. However, I
would expect them to be under pressure to stabilise prices within a reasonable timeframe in order to
maintain market share in the face of tepid demand. Higher inflation could also encourage workers to push
for higher wages, in turn setting in motion an upward spiral of higher prices and higher nominal wages.
But as I argue above, the still high pool of available labour is likely to continue dampening their wage-
bargaining power and I would expect companies to resist higher wages in an effort to contain costs ahead
of what is likely to be an uncertain two years for the UK. This was certainly the case in the 12 months to
September 2009 with headline CPI-inflation falling from 5.2% yoy to 1.1% yoy (see Figure 11).
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Price of imported goods
Headline CPI-inflation
Year-on-year % change
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Sterling Nominal Effective Exchange Rate
(NEER), Jan 2005 = 100

10. 10
Figure 13: Rising inflation in past six months looks a lot like the upsurge in 2008…when BoE cut rates
Source: Bank of England
BoE more likely to chose to look beyond recent rise in UK inflation
The forward-looking Bank of England is aware of these possible dynamics and so the question is whether it
is willing to look beyond a potentially temporary rise in UK inflation – as Governor Mark Carney suggested
on 21st
March – or whether it will try to short-circuit any self-reinforcing rise in prices. I would note that the
BoE started to aggressively cut its policy rate in October 2008, after headline CPI-inflation had hit a multi-
year high of 5.2% yoy in September 2008 (see Figure 13) – evidence of the central bank’s willingness to
look beyond likely temporary factors.
My base-line scenario is that once again the BoE will look beyond the current rise in UK inflation, unless at
least one of three conditions materialise:
(1) Nominal wage growth accelerates, comfortably outstripping headline inflation and driving
consumption growth;
(2) Commercial bank lending picks up significantly; and
(3) Sterling depreciates materially from current levels, exacerbating imported and in turn headline
inflation (see Figure 12).
I expect that neither (1) or (2) will materialise any time soon and that while the risks to Sterling are probably
biased to the downside, Sterling is unlikely to weaken sufficiently to push the BoE into hiking interest rates.
I would however expect the BoE to keep a possible rate hike this year firmly on the table in order to help
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Jan 00 Sep 01 May 03 Jan 05 Sep 06 May 08 Jan 10 Sep 11 May 13 Jan 15 Sep 16
Bank of England policy rate, % Headline CPI-inflation, % year-on-year
Core CPI-inflation, % year-on-year

11. 11
put a floor under Sterling and a ceiling on inflation expectations. A Reuters poll released on 24th
January
revealed a median 20% probability of a BoE rate hike this year and the market is currently pricing in about
15bp of rate hikes over the next 12 months.