Sharp falls in annual consumer and retail price inflation in December have prompted claims that the economy stands on the brink of deflation, justifying today’s further reduction in Bank rate to 1.0%. The declines, however, are entirely explained by the 2.5 percentage point cut in VAT, falling energy costs and – in the case of the RPI – lower interest rates. Underlying inflation has yet to show much response to economic weakness.

Annual CPI inflation fell from 4.1% in November to 3.1% in December. Since its first statistical release a fortnight ago, the Office for National Statistics (ONS) has published a December number for the “CPI at constant tax rates” (CPI-CT), i.e. adjusted for the impact of the VAT cut. This incorporates official estimates of the extent to which the reduction was passed on by retailers and other consumer suppliers. Annual CPI-CT inflation actually rose in December, from 3.9% to 4.1% – see chart.

The annual increase in the CPI’s energy component moved lower in December, from 16.7% to 12.2%, mainly reflecting falling petrol prices. If the rate of change had remained at 16.7%, annual CPI-CT inflation would have risen further, to an estimated 4.3%.

To gauge underlying pressures, it is helpful to exclude both energy prices and the effect of the VAT reduction. The annual increase in the CPI excluding energy eased from 3.1% to 2.3% in December. Without the VAT cut, however, the December number would have risen to an estimated 3.4% – equal to the peak reached in August / September.

Annual RPI inflation dropped from 3.0% in November to just 0.9% in December. The ONS does not publish an RPI series at constant tax rates but RPIY – which excludes indirect taxes and mortgage interest costs – rose an annual 3.9% in December, unchanged from November.

The severe recession will rapidly reduce domestic inflationary pressures but the slump in sterling is having an offsetting impact, with manufactured import prices rising by an annual 14% in November (December figures are due next week). Energy price effects will ensure a further significant drop in headline CPI and RPI rates during 2009 but the decline is likely to be smaller than the MPC and consensus expect, while VAT-adjusted non-energy inflation may remain above 2%.