The charts below update forecasts for consumer and retail price inflation presented in a previous post. Recent CPI outturns have been in line with the earlier projection but RPI figures have been higher than expected, partly reflecting house price gains. (House prices enter the RPI via a component measuring housing depreciation costs.)

The new forecasts are based on the same underlying approach as described in the earlier post but assumptions about food, energy and house prices have been updated. In addition, the projection for CPI inflation excluding unprocessed food and energy over the next year has been raised slightly to take account of recent exchange rate weakness. (At yesterday's close of 77.5, sterling's effective rate was 7% below the level assumed in the August Inflation Report.)

From its September level of 1.1%, annual CPI inflation is projected to rise sharply to nearly 3% in January before drifting lower over the remainder of 2010. The increase reflects unfavourable energy price base effects and the reinstatement of a 17.5% standard rate of VAT from January. The VAT change is assumed to add 0.5% to the CPI – equal to an estimate by the Office for National Statistics of the initial impact of last December's reduction to 15%.

The projections are arguably conservative in two respects. First, energy utility tariffs are assumed to fall by 5% around the end of 2009, reflecting government pressure on suppliers to pass on earlier reductions in wholesale gas prices. Gas costs, however, have rebounded recently while companies may continue to resist cuts on the basis that profits need to rise to finance huge future investment requirements. Without a reduction, the January inflation rate might hit the 3.1% level necessitating an explanatory letter from Bank of England Governor King.

Secondly, annual inflation excluding unprocessed food and energy prices, and adjusted for the VAT effect, is projected to fall to 1.5% by the end of 2010 in lagged response to slower monetary growth, explaining the drift lower in the headline rate later next year. This compares with a current estimated rate of 2.5%. Core inflation has recently proved stickier than most forecasters expected and this could continue, particularly if the exchange rate remains weak.

The projections are significantly higher than those published by the Bank of England in the August Inflation Report – this shows average inflation of 2.1% in the first quarter of 2010, falling to 1.5% by the fourth quarter assuming an unchanged level of Bank rate. With recent figures above its expectations, and the pound much weaker, the Bank is likely to revise up its near-term forecasts once again in the November Inflation Report.

RPI inflation will rise even more sharply than the CPI measure, reflecting unfavourable mortgage rate and house price base effects in addition to the factors cited above. From -1.4% in September, the headline rate is forecast to rise to more than 3% next spring based on an unchanged Bank rate, with higher levels obviously implied by any increase in official rates. (The alternative scenario in the chart assumes that the average mortgage rate rises by half the amount of the change in Bank rate, consistent with the roughly 60% share of variable-rate loans in total mortgage debt outstanding.) The projections are based on house prices stabilising at current levels – probably again conservative, particularly if Bank rate remains at 0.5%.