Inflation to balloon early next year
The rise in consumer price inflation from an annual 1.1% in September to 1.5% in October marks the start of a trend that is likely to carry the headline rate above 3% in January, necessitating a sixth explanatory letter from Bank of England Governor Mervyn King to the Chancellor.
Inflation should subside over the remainder of 2010 but is unlikely to fall below the 2% target, as forecast by the Bank of England in the November Inflation Report.
The headline rate continues to be flattered by last December's VAT cut and lower energy prices than a year ago. The Office for National Statistics has estimated an effect on the headline rate from VAT and duty changes at 0.5%, suggesting that inflation would be 2% in October in the absence of the reduction. On the same basis, core inflation – excluding energy, food, alcohol and tobacco – might stand at 2.7% rather than the reported 1.8%.
Petrol prices accounted for much of the rise in headline inflation between September and October but there were also significant upward contributions from cars, flights, food, DVDs, computer games and landline telephones.
Inflation has overshot the Bank's forecasts by an embarrassingly large margin this year. The central projection in the May Inflation Report showed the CPI headline rate falling to just 0.4% in the fourth quarter. Further increases in November and December are likely to result in an outturn of 2% or higher. The Bank's forecasts have proved too low because it overestimated the impact of economic slack on core price trends while underestimating upward pressure from exchange rate depreciation and global commodity prices. There is little sign that it has learnt from its mistake, with the November Report continuing to place heavy emphasis on 'output gapology' while playing down external price risks.
The RPI headline rate moved up from -1.4% to -0.8% between September and October and will rise much more sharply than CPI inflation over the next six months, reflecting house price and mortgage rate base effects. Even assuming house price stabilisation, RPI inflation is likely to reach about 4% by next spring, with higher figures obviously implied by any increase in official interest rates. Governor King last week stated that the Bank intended to "look through the short-term rise in inflation" but there is a risk that sharply higher headline rates will destabilise inflationary expecations in the absence of any policy response.
