Recent talk of imminent deflation has been highly misleading. Headline CPI and RPI inflation have been artificially depressed by the December VAT cut, falling world energy prices and interest rate reductions. Underlying inflation has been picking up in response to the plunge in the exchange rate. February numbers released today confirm the trend and cast doubt on the MPC’s forecast of a big decline in the headline CPI rate later in 2009.

Despite a favourable impact from lower energy costs, annual CPI inflation rose from 3.0% in January to 3.2% in February. This was well above both the consensus expectation of 2.6% and a February Inflation Report projection of 2.7% for the first quarter. Inflation would be significantly higher but for December’s VAT cut: the CPI at constant tax rates rose an annual 4.2% in February.

Underlying inflation is often measured by the CPI excluding unprocessed food and energy. The annual rate of change of this index rose from 1.9% to 2.3% between January and February. Without the VAT cut, the February figure would have been over 3% – above the peak of 2.8% in August / September last year.

The culprit is the plunge in sterling and a resulting surge in non-energy import costs – manufactured import prices rose an annual 14% in January. In his latest explanatory letter, Bank of England Governor Mervyn King notes that “much of the strength of the outturn appears to be concentrated in components where a large share of goods is imported”.

In his last letter, in December, Mr. King suggested that he would next have to write when annual CPI inflation fell below 1% later in 2009. The MPC, like the consensus, has underestimated the inflationary impact of sterling's slump. Recent cuts in energy tariffs and rising economic slack will pull inflation lower but sub-1% readings are unlikely barring a significant exchange rate recovery. Headline inflation will rebound sharply in early 2010 as VAT and energy benefits reverse.