UK Inflation Watch

NOMURA GLOBAL ECONOMICS

12 August 2010 Introducing 2012

Philip Rush  Inflation overview: We believe underlying inflationary pressures are weak, but
UK Economist another 2.5pp VAT hike in January 2011 will probably keep it above target until 2012.
+44 20 7102 9595
philip.rush@nomura.com  Monetary policy: This month, BoE Governor Mervyn King is likely to write his third
consecutive letter explaining why inflation is so far above target.

Table of Contents
Inflation overview
Focus: Introducing 2012
Focus: Re-attributing the wedge 3
Month in detail
Inflation forecasts table
CPI components
Nomura International Plc.
Page  Month in focus: We expect inflation to moderate further in July because of transport
1 and recreation. We forecast CPI inflation at 3.1% and RPI inflation at 4.8%.
2
Subdued earnings growth and a persistently large output gap are likely to bear down on
inflation. We believe underlying inflation – ignoring temporary “one-off” – shocks to be
4 weak. Because of a number of shocks to the price level from the VAT hike, higher
5 commodity prices, sterling’s depreciation and the car-scrappage scheme, underlying
6 inflation remains difficult to perceive. In the absence of underlying inflationary pressures,
the headline rate of inflation should ultimately fall back as the price level shocks fall out of
the base period used in calculating the annual rate of inflation.

Unfortunately, another large “one-off” shock is coming in January 2011 when a further
2.5pp hike in VAT is implemented by the government. Retailers will likely phase the
increase in between December 2010 and February 2011 and transmit a greater
proportion of the hike onto consumers than they did in 2010. Failure to assume a greater
transmission means expecting retailers to bear a greater burden and absorb more of it
into their margins. The VAT change adds around one percentage point to our inflation
forecasts, but the impact on the annual rate of inflation will drop out of the base a year
later and will likely result in subdued inflation throughout 2012.

Insofar as policymakers continue to believe that a large and persistent output gap will
drag inflation back below target in 2012, the VAT change should not alter the course of
monetary policy. However, inflation expectations of individuals are heavily influenced by
current perceptions, so a prolonged period of above-target inflation could cause higher
expectations to become entrenched. This month, we expect the BoE Governor to write a
third consecutive letter explaining why inflation is so far above target in July.

Figure 1. Annual inflation rate forecasts Figure 2. Inflation drivers

% y-o-y Misc. 0.27

6
Restaurants 0.37
5 Education 0.11
Recreation 0.20
4
Communication 0.14
3 Transport 1.34
Health 0.05
2
Furniture 0.19
1 Housing 0.08
Clothing -0.07
0
Alcohol 0.20
RPI
-1 Food 0.21
CPI
-2 CPI target -0.50 0.00 0.50 1.00 1.50
Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Contributions to the 12 month CPI inflation rate
Source: ONS and Nomura Global Economics Source: Nomura Global Economics

Any authors named on this report are research analysts unless otherwise indicated.
Please see analyst certifications and important disclosures starting on page 8.
UK Inflation Watch
FOCUS: INTRODUCING 2012
Low underlying inflation
should be revealed in
2012, in our view....
...because of low unit
wage costs and plenty of
excess capacity
Modest wage settlements
and higher productivity
growth suppress costs
A large and persistent
output gap should bear
down on inflation
Figure 3. Unit wage costs
% y-o-y
12
10
8
6 1
4
2 -2
0
-2
1Q90 1Q94 1Q98 1Q02
Source: ONS and Nomura Global Economics
Nomura Global Economics
Underlying inflation in the UK is weak, in our view. Restrained growth in labour costs and
a persistently large output gap should subdue inflation.
In 2012, the “one-off” shocks from a series of VAT changes will drop out of the base used
in the headline annual rate. This is a simple statistical effect that cannot be disputed.
Once this occurs, and in the absence of any further major “one-off” shocks, the rate of
underlying inflation will be revealed. Of course, we do not know for certain when any
“one-off” shock will materialise in either the positive or negative direction. But if we
assume these weighted shocks are relatively symmetric on either side of the rate of
underlying inflation then headline inflation should be unbiased away from this underlying
forecast. In our view, the risk is that these shocks remain skewed to the upside and thus
we also see the risks to our 1.2% CPI and 2.3% RPI inflation forecasts in 2012 to the
upside.
It is clear from this that understanding the underlying rate of inflation is crucial to long-
term inflation forecasting. We see two key factors behind our low 2012 inflation forecasts.
First, inflationary pressures from wage growth should be contained provided long-term
inflation expectations remain anchored, in our view. Second, the large fall in output and
to a lesser extent, the rise in unemployment, have probably opened up a substantial
margin of spare capacity in the economy.
Excess capacity in the labour market is helping to keep real wage growth subdued
because competition from unemployed workers reduces the bargaining position of
workers during wage negotiations. Furthermore, fiscal consolidation plans are likely to
favour pay restraint over job cuts where possible, particularly because of resistance from
unions, who will not want to lose members. Unions remain relatively powerful in the
public sector. Job creation is also likely to be depressed by fiscal consolidation, such that
the productivity of workers increases. A combination of restrained increases in the wage
bill and high productivity growth would keep unit wage cost growth subdued. If firms are
not facing large and sustained cost increases, there will be a reduced need for price rises.
Or from the other perspective, low wage growth constrains the purchasing power of
consumers, preventing demand from pushing up prices.
Rather than demand inflating prices, we believe there to be a large shortfall of demand
relative to supply potential, which would be disinflationary. Even assuming that demand
is higher than officially estimated and that potential GDP growth has been very low and
will remain impaired, there is still a sizable amount of excess capacity in the UK economy.
Indeed, we expect the negative output gap to persist until the second half of 2014. If
companies have a large amount of excess capacity, there is an economic incentive to
compete hard for custom and that is inconsistent with making uncompetitive price rises.
Figure 4. Output gap
% of potential GDP
2Q 2010
5
4
3
2
0
-1
-3
-4
-5
1Q06 1Q10 1Q79 1Q84 1Q89 1Q94 1Q99 1Q04 1Q09
Source: Nomura Global Economics
2 12 August 2010
UK Inflation Watch
FOCUS: RE-ATTRIBUTING THE CPI-RPI WEDGE
The ONS has substantially
revised its reconciliation
of the CPI-RPI wedge
Although it does not
impact past or future ONS
prints, it affects forecasts
A previously stretched
component has been
revised to be sustainable
Figure 5. Re-attributing the CPI-RPI wedge
pp, change
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
Jun-05 Mar-06 Dec-06 Sep-07 Jun-08 Mar-09 Dec-09
Total housing
o/w other
Other differences
Source: ONS and Nomura Global Economics
Nomura Global Economics
Changes to the ONS methodology for reconciling the difference between CPI and RPI
inflation triggers substantial revisions to the drivers of the CPI-RPI wedge.
The ONS has quietly revised its methodology for reconciling the difference between CPI
and RPI inflation. An explanatory document will be published by the ONS on 17 August –
when the July inflation data are released – alongside the full revised history. Although
this will not prompt any revisions to headline CPI or RPI inflation or indices, the amended
history may influence the speed at which we expect the CPI-RPI wedge to normalise.
The ONS produce the CPI and RPI based on largely the same price surveys. However,
there are differences in aggregation method (the formula effect), coverage (notably from
housing), and a catch-all residual term that includes the “other differences including
weights”. Under the new statistically superior approach, contributions to the 12-month
rate are employed such that the reconciliation of causality to components is additive.
Under the old system, differences in the actual growth rates were employed such that the
components were not additive. This led to the “other differences including weights” term
collating all the residual errors that were inappropriately aggregated. This may not sound
like much at first pass, but the methodological change has proven to be hugely significant
to the historical reconciliation. Although the methodological change to the reconciliation
approach will not affect past or future inflation prints, it may influence the forecasts of
economists because the causality is conventionally considered in reverse. The ONS
estimate CPI and RPI then calculate the wedge, but economists typically forecast the CPI
and the wedge then calculate RPI. We welcome the change as the wedge should be
“better behaved” from a forecaster’s perspective and we will evaluate our forecasting
methods for the wedge when full details and history are released next week.
Figure 5 illustrates the change in the historical reconciliation under the new system (N.B.
the formula effect was broadly unrevised). Much of the wedge previously allocated to
“other differences including weights” has been reclassified to housing and particularly
depreciation therein – interesting in the context of adding owner-occupied housing costs
to the CPI. We have repeatedly highlighted the contribution of the “other differences” as
unusual and unsustainably large. Under the revised history, the contribution still appears
stretched relative to its average since June 2005 (i.e. the full history currently available),
as the revision over this short sample period has largely been to shift the level. As such,
we continue to expect the contribution from this factor to normalise in our RPI forecast,
but we will study the full data and methodology once they become available.
Bottom line: Methodological changes to the way the ONS reconciles the differences
between CPI and RPI inflation have caused a substantial re-attribution to the drivers of
the CPI-RPI wedge. Headline indices are unrevised, only the drivers of the difference are.
Figure 6. Forecasting the CPI-RPI wedge
pp, y-o-y
4
Housing (MIPS plus other including depreciation)
3 Coverage
Formula
2 Other
1
0
-1
-2
o/w MIPS -3
Coverage Jun-05 Jul-06 Aug-07 Sep-08 Oct-09 Nov-10 Nov-11
Source: ONS and Nomura Global Economics
3 12 August 2010
UK Inflation Watch

MONTH IN DETAIL

Summary
July usually features a large seasonal reduction in the price of clothing and furniture,
which we expect to be repeated in 2010. Of more interest is the change in headline
annual CPI inflation, which we expect to be primarily attributed to recreation and, for the
third consecutive month, transport. On balance, we forecast CPI inflation to slow by
0.1pp to 3.1% y-o-y and for RPI inflation to slow by 0.2pp to 4.8% y-o-y. This equates to
negative month-on-month growth of 0.2% in both the CPI and RPI which, if our forecast
is accurate, would result in an RPI level of 223.6.

Details
Both clothing and footwear prices seasonally decline in July. Indeed, this has occurred in
every month since CPI records began so it is a pattern that we hold with conviction. We
expect a sizeable decline in clothes and footwear prices. However, our forecast is on a
par with that experienced in July 2009, so we expect this to be a relatively small
contributing factor to the change in the annual rate of inflation. Similarly, furniture prices
have exhibited a seasonal decline in every July on record, but our expected decline of
2.5% m-o-m is close to that experienced in 2009. As such, the large change in furniture
prices we expect would not affect the annual rate of CPI inflation.

Transport is a dominant sector driving changes in the annual CPI inflation rate in July, in
our view. If this component subtracts 0.06pp from the annual rate of headline CPI
inflation, as we expect, it would be the fourth consecutive negative contribution to the
change in the annual inflation rate, albeit a third of the magnitude as that recorded in
June. Our reasons for this are twofold. First, car prices surged in July 2009 because of
distortions from the car-scrappage scheme, which has since been terminated, so we do
not expect a repeat. Instead, we expect a slight decline in the purchase price of vehicles
because of a fall in second-hand car prices. Second, but of much less importance, we
expect a decline of 0.5% m-o-m in the petrol price in July 2010. The disinflationary impact
of these changes is partially offset by our expectation for a larger increase in the price of
transport services (i.e. air and sea fares) than that experienced in 2009. The other major
contributing factor we expect arises from recreation – namely the “other recreation”
subcomponent. In 2009, the price of games and toys was unchanged. In 2010, we expect
a return to the usual seasonal decline and for this to subtract from the headline annual
rate of CPI inflation.

The total reduction in the annual CPI inflation rate of 0.18pp is the predominant factor
behind the 0.24pp reduction in the RPI inflation rate that we forecast. Other than this, we
expect the narrowing in the CPI-RPIX wedge to arise from mortgage interest payments
and for the other factors to remain broadly unchanged.

Figure 5. Forecasts for the CPI components Figure 6. Contributions to the change in the CPI inflation rate

Weight Nom ura Forecast Misc. -0.02

% % m-o-m % y-o-y Restaurants 0.01
CPI 100 -0.2 3.1 Education -0.07 0.00
Food and non-alcohol 11 -0.5 1.8
Recreation
Alcohol and tobacco 4 -0.1 5.0
Communication -0.02
Clothing and footw ear 6 -3.2 -1.3
Transport -0.06
Housing and utilities 13 0.3 0.7
Furniture and equip. 6 -2.5 2.6 Health 0.00
Health 2 0.5 2.4 Furniture 0.02
Transport 16 1.2 8.4 Housing 0.02
Communication 3 -0.7 5.6 Clothing -0.01
Recreation and culture 15 -0.3 1.3 Alcohol -0.02
Education 2 0.0 5.2 Food 0.00
Restaurants and hotels 13 0.2 3.0
Miscellaneous 10 0.2 2.8 -0.08 -0.06 -0.04 -0.02 0.00 0.02 0.04
Contributions to the change in the 12 month CPI inflation rate
Source: Nomura Global Economics Source: Nomura Global Economics

Nomura Global Economics 4 12 August 2010

UK Inflation Watch

INFLATION FORECASTS TABLE

CPI RPI "Core" CPI RPIX
% m -o-m % y-o-y % m -o-m % y-o-y % y-o-y % m -o-m % y-o-y
Jul-09 110.941 0.0 1.8 213.4 0.0 -1.4 1.8 0.0 1.2
Aug-09 111.440 0.4 1.6 214.4 0.5 -1.3 1.8 0.5 1.4
Sep-09 111.485 0.0 1.1 215.3 0.4 -1.4 1.7 0.4 1.3
Oct-09 111.680 0.2 1.5 216.0 0.3 -0.8 1.8 0.3 1.9
Nov-09 111.994 0.3 1.9 216.6 0.3 0.3 1.9 0.3 2.7
Dec-09 112.623 0.6 2.9 218.0 0.6 2.4 2.8 0.6 3.8
Jan-10 112.439 -0.2 3.5 217.9 0.0 3.7 3.1 0.0 4.6
Feb-10 112.854 0.4 3.0 219.2 0.6 3.7 2.9 0.6 4.2
Mar-10 113.506 0.6 3.4 220.7 0.7 4.4 3.0 0.7 4.8
Apr-10 114.157 0.6 3.7 222.8 1.0 5.3 3.1 1.0 5.4
May-10 114.417 0.2 3.4 223.6 0.4 5.1 2.9 0.4 5.1
Jun-10 114.587 0.1 3.2 224.1 0.2 5.0 3.1 0.2 5.0
Jul-10 114.375 -0.2 3.1 223.6 -0.2 4.8 3.0 -0.3 4.7
Aug-10 114.862 0.4 3.1 224.4 0.4 4.7 2.9 0.4 4.6
Sep-10 114.904 0.0 3.1 225.4 0.4 4.7 2.9 0.4 4.6
Oct-10 115.001 0.1 3.0 225.6 0.1 4.5 2.7 0.1 4.5
Nov-10 115.076 0.1 2.8 225.9 0.1 4.3 2.6 0.1 4.2
Dec-10 115.438 0.3 2.5 226.9 0.4 4.1 2.3 0.4 3.9
Jan-11 115.513 0.1 2.7 227.1 0.1 4.2 2.8 0.0 4.0
Feb-11 116.358 0.7 3.1 228.9 0.8 4.4 3.0 0.8 4.3
Mar-11 116.836 0.4 2.9 230.2 0.6 4.3 3.1 0.5 4.1
Apr-11 117.105 0.2 2.6 231.2 0.4 3.8 2.9 0.5 3.6
May-11 117.331 0.2 2.5 231.8 0.2 3.6 2.8 0.2 3.4
Jun-11 117.350 0.0 2.4 231.8 0.0 3.4 2.5 0.0 3.2
Jul-11 117.117 -0.2 2.4 231.2 -0.2 3.4 2.4 -0.4 3.1
Aug-11 117.534 0.4 2.3 232.0 0.3 3.4 2.4 0.3 3.0
Sep-11 117.439 -0.1 2.2 232.7 0.3 3.2 2.4 0.3 2.9
Oct-11 117.453 0.0 2.1 232.6 -0.1 3.1 2.3 0.0 2.8
Nov-11 117.505 0.0 2.1 232.9 0.1 3.1 2.3 0.1 2.8
Dec-11 117.581 0.1 1.9 233.4 0.2 2.9 n.a. 0.1 2.5
Jan-12 116.878 -0.6 1.2 232.3 -0.5 2.3 n.a. -0.5 1.9
Feb-12 117.503 0.5 1.0 233.7 0.6 2.1 n.a. 0.6 1.7
Mar-12 117.962 0.4 1.0 234.9 0.5 2.0 n.a. 0.4 1.7
Apr-12 118.337 0.3 1.1 236.3 0.6 2.2 n.a. 0.6 1.8
May-12 118.537 0.2 1.0 236.8 0.2 2.2 n.a. 0.2 1.8
Jun-12 118.531 0.0 1.0 237.0 0.1 2.2 n.a. 0.0 1.7
Jul-12 118.353 -0.2 1.1 236.5 -0.2 2.3 n.a. -0.3 1.8
Aug-12 118.882 0.4 1.1 237.5 0.4 2.4 n.a. 0.4 1.9
Sep-12 119.095 0.2 1.4 238.8 0.6 2.6 n.a. 0.5 2.1
Oct-12 119.107 0.0 1.4 238.4 -0.2 2.5 n.a. -0.1 2.0
Nov-12 119.053 0.0 1.3 238.4 0.0 2.4 n.a. 0.0 1.9
Dec-12 119.207 0.1 1.4 239.1 0.3 2.5 n.a. 0.1 2.0

QUARTERLY AVERAGES
Q1 - 10 112.933 n.a. 3.3 219.3 n.a. 4.0 3.0 n.a. 4.5
Q2 - 10 114.387 n.a. 3.5 223.5 n.a. 5.1 3.0 n.a. 5.2
Q3 - 10 114.714 n.a. 3.1 224.5 n.a. 4.7 2.9 n.a. 4.7
Q4 - 10 115.171 n.a. 2.7 226.1 n.a. 4.3 2.5 n.a. 4.2
Q1 - 11 116.235 n.a. 2.9 228.8 n.a. 4.3 3.0 n.a. 4.1
Q2 - 11 117.262 n.a. 2.5 231.6 n.a. 3.6 2.7 n.a. 3.4
Q3 - 11 117.364 n.a. 2.3 232.0 n.a. 3.3 2.4 n.a. 3.0
Q4 - 11 117.513 n.a. 2.0 232.9 n.a. 3.0 2.3 n.a. 2.7
Q1 - 12 117.447 n.a. 1.0 233.6 n.a. 2.1 n.a. n.a. 1.8
Q2 - 12 118.468 n.a. 1.0 236.7 n.a. 2.2 n.a. n.a. 1.8
Q3 - 12 118.777 n.a. 1.2 237.6 n.a. 2.4 n.a. n.a. 2.0
Q4 - 12 119.122 n.a. 1.4 238.7 n.a. 2.5 n.a. n.a. 2.0

ANNUAL AVERAGES
2009 2.2 -0.5 1.8 2.0
2010 3.1 4.5 2.9 4.6
2011 2.4 3.6 2.6 3.3
2012 1.2 2.3 n.a. 1.9
Source: ONS, Nomura Global Economics. Note: Shaded cells are forecasts. “Core” CPI excludes food, alcohol, tobacco & energy.

Nomura Global Economics 5 12 August 2010

 UK Inflation Watch

COMPONENTS OF THE CPI

01: Food and non-alcoholic beverages 02: Alcoholic beverages and tobacco

% y-o-y % y-o-y
14 CPI 8

12 Food and non-alc. 7 CPI

beverages Alcohol and tobacco
10 6

8 5

6 4

4 3

2 2

0 1

-2 0
Jan-05 Jan-07 Jan-09 Jan-11 Jan-05 Jan-07 Jan-09 Jan-11

Source: ONS, Nomura Global Economics. Source: ONS, Nomura Global Economics.

03: Clothing and footwear 04: Housing, water, electricity, gas and other fuels

% y-o-y % y-o-y
6 16
4 14

2 12
10
0
8
-2
6
-4
4
-6
2
-8 CPI 0
-10 Clothing and footwear -2 CPI
-12 -4 Housing and household services
Jan-05 Jan-07 Jan-09 Jan-11 Jan-05 Jan-07 Jan-09 Jan-11

Source: ONS, Nomura Global Economics. Source: ONS, Nomura Global Economics.

05: Furniture, household equipment and maintenance 06: Health

% y-o-y % y-o-y
6 CPI 6
CPI
5 Furniture and
household goods 5 Health
4
4
3

2 3

1
2
0
1
-1

-2 0
Jan-05 Jan-07 Jan-09 Jan-11 Jan-05 Jan-07 Jan-09 Jan-11

Source: ONS, Nomura Global Economics. Source: ONS, Nomura Global Economics.

Nomura Global Economics 6 12 August 2010

 UK Inflation Watch

COMPONENTS OF THE CPI (continued)

07: Transport 08: Communication

% y-o-y % y-o-y
12 8
CPI
10 6 Communication
CPI
8 Transport 4
6
2
4
0
2
-2
0

-2 -4

-4 -6
Jan-05 Jan-07 Jan-09 Jan-11 Jan-05 Jan-07 Jan-09 Jan-11

Source: ONS, Nomura Global Economics. Source: ONS, Nomura Global Economics.

09: Recreation and culture 10: Education

% y-o-y % y-o-y
6 16 CPI
CPI
5 14
Recreation and Education
4 culture 12
3
10
2
8
1
6
0
-1 4

-2 2

-3 0
Jan-05 Jan-07 Jan-09 Jan-11 Jan-05 Jan-07 Jan-09 Jan-11

Source: ONS, Nomura Global Economics. Source: ONS, Nomura Global Economics.

11: Restaurants and hotels 12: Miscellaneous goods and services

% y-o-y % y-o-y
6 6
CPI
5 5 Miscellaneous

4 4

3 3

2 2

CPI
1 1
Restaurants and hotels
0 0
Jan-05 Jan-07 Jan-09 Jan-11 Jan-05 Jan-07 Jan-09 Jan-11

Source: ONS, Nomura Global Economics. Source: ONS, Nomura Global Economics.

Nomura Global Economics 7 12 August 2010

UK Inflation Watch

ANALYST CERTIFICATIONS
I Philip Rush hereby certify (1) that the views expressed in this report accurately reflect my personal views about any or all of the subject securities or
issuers referred to in this report, (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views
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Nomura Global Economics 8 12 August 2010