With a further rise to 1.9% in November, annual consumer price inflation remains on course to exceed 3% in January, necessitating a sixth explanatory letter from Bank of England Governor Mervyn King to the Chancellor. The November increase was ahead of market expectations but in line with the forecast presented in a prior note.
While commentary will focus on the role of higher fuel prices, the real story is a further pick-up in “core” inflation. Excluding energy, food, alcohol and tobacco, consumer prices rose an annual 1.9% in November, up from 1.8% in October. Had VAT not been cut last December, core inflation would probably stand at 2.7-2.8% (based on an estimate by the Office for National Statistics of the impact of the reduction).
Core inflation has exceeded Bank of England and consensus forecasts by a wide margin this year. The forecasts overestimated the disinflationary impact of rising economic slack while underestimating offsetting upward pressure from the collapse in the exchange rate. The November rise may partly reflect some retailers hiking prices ahead of the VAT reversal.
Further fuel price effects and the dropping-out of last December’s VAT cut are projected to lift headline inflation to 2.6-2.7% this month. This would yield a fourth-quarter average of 2.0%, above the 1.85% forecast in the November Inflation Report. The headline rate may reach 3.2-3.3% in January as VAT is raised before moderating later in 2010, while remaining above the 2% target – see the earlier note.
The retail price headline rate jumped from -0.8% in October to 0.3% in November, in line with the prior forecast, and is on course to reach 4% or higher by next spring. The annual rise excluding mortgage interest costs and housing depreciation climbed from 2.4% in October to 3.0% last month; the VAT reversal, energy effects and recovering house prices will push the headline rise well above this level in early 2010.
At the November Inflation Report press conference, Governor King stated that the Monetary Policy Committee intended to "look through the short-term rise in inflation" but there is a risk that sharply higher headline rates will destabilise inflationary expectations in the absence of any policy response. With fiscal plans widely judged to lack credibility, the UK can ill afford any loss of confidence in the Bank's inflation-fighting determination.