Contrary to the consensus interpretation, recent inflation news has been distinctly poor, with the cut in VAT and lower fuel prices masking a deteriorating underlying trend due to surging non-energy import costs.

The superficial view is that prices are slowing fast, with annual headline consumer price inflation down to 3.0% in January from a peak of 5.2% last September. However, using the CPI at constant tax rates, which adjusts for the reduction in VAT, the decline has been much smaller, from 5.0% to 4.1%. Moreover, this fall is fully explained by a drop in energy price inflation.

Underlying inflation is often measured by the CPI excluding unprocessed food and energy. The annual increase in this index declined from 2.8% to 1.9% between September and January but would have risen – to an estimated 3.0% – without the VAT reduction.

The culprit is the officially-sanctioned plunge in the exchange rate and a resulting large rise in non-energy import costs (import prices of manufactured goods climbed 14% in the year to December). Today’s Office for National Statistics release notes upward contributions to annual CPI inflation from a range of categories dependent on foreign suppliers, including games and toys, furniture, household and personal appliances and package holidays.

The recession will restrain domestically-generated inflation but higher import costs may continue to have an offsetting impact, barring a significant exchange rate rally. Energy effects will ensure a further fall in the headline CPI increase over coming months but the decline may disappoint MPC and consensus expectations and inflation will rebound in early 2010 as VAT and energy benefits reverse.