A previous post suggested that consumer price inflation would rise to an annual 3.4% in January and average 3.2% in the first quarter. This now looks too high, for three reasons.

First, the British Retail Consortium (BRC) shop price survey for January showed a rise in non-food goods inflation from an annual 1.4% in December to 1.9% – smaller than expected given the return of the standard VAT rate to 17.5%. A larger proportion of retailers than previously thought may have either raised prices before January or absorbed the increase in margins, although the latter effect could prove temporary.

Secondly, CPI food inflation probably slowed in January. The annual increase in the BRC food price index fell from 3.7% in December to 2.9%. Similarly, producer output prices for food and beverages rose an annual 1.1% last month, down from 1.8% in December – see chart.

Thirdly, the 7% cut in gas tariffs by British Gas – effective immediately – is likely to be followed by other suppliers over coming weeks, implying a reduction of 0.15% in the CPI.

Petrol prices will have a large upward effect – an estimated 0.25 percentage points – on the CPI annual rate in January, reflecting both a rise last month, partly due to the VAT hike, and a fall in January 2009.

Based on the above, CPI inflation may rise to an annual 3.2% in January before falling back to 2.9% in February and March, implying a first-quarter average of 3.0%.

Bank of England Governor Mervyn King will be able to explain a move above 3% as the result of the VAT hike and petrol price effects. The bigger issue is the stickiness of "core" price trends: the CPI excluding unprocessed food and energy rose by 2.9% in the year to December and at a similar annualised rate over the last three months (adjusting for seasonal influences).

With the economy recovering, the "output gap" smaller than generally assumed and the weak exchange rate exerting upward pressure on goods prices, core inflation may continue to frustrate MPC and consensus hopes of a significant slowdown. Coupled with further indirect tax hikes after the election, this may keep headline CPI inflation well above the 2% target for the foreseeable future.