Today's Financial Times draws attention to the huge deterioration in the UK's relative inflation performance caused by last year's plunge in the exchange rate, a topic discussed in an earlier post. Its observations, however, should be qualified in two respects.

First, the FT uses the CPI excluding indirect taxes as a gauge of "true" inflation, i.e. adjusting for the impact of December's VAT cut. This rose an annual 3.8% in April versus a 2.3% increase in the headline CPI. A better measure, however, is the CPI at constant tax rates (CPI-CT), which climbed by a smaller 3.4%.

Moreover, both of these alternative indices are based on the assumption that the VAT reduction was passed on in full – highly unlikely. Using a more realistic estimate of 50% pass-through, "true" inflation in April was 2.8-2.9% (i.e. halfway between the headline 2.3% and 3.4% CPI-CT increases).

Secondly, as discussed in a post last week, recent sterling strength – if sustained – promises a reduction in imported inflationary pressures later in 2009. The MPC's central-case forecast that the annual CPI increase will slow to 0.4% by the fourth quarter looks much too optimistic but the gap between UK and US / Eurozone inflation is peaking and should narrow significantly.

For the gilt market, supply is likely to represent a greater threat than relatively high UK inflation. The stock of gilts in market hands should shrink by about £50 billion over March-July, with Bank of England purchases of £120 billion offsetting net issuance of £70 billion. If the MPC were to suspend QE purchases from August, however, the market would need to absorb supply of £130-135 billion in the final eight months of 2009-10. (The DMO plans to issue a net £203 billion this fiscal year, based on the Treasury's forecast of public net borrowing of £175 billion.)

In other news today, minutes of this month's MPC meeting show that that some members favoured expanding QE by £75 billion rather than £50 billion, while the Committee discussed writing a letter to the Chancellor requesting an increase in the £150 billion limit "should economic conditions require it". This is likely to fuel expectations that gilt-buying will be extended beyond early August but such a decision will depend importantly on forthcoming monetary data (provisional April broad money numbers are released tomorrow).

Meanwhile, Inflation Report forecast tables show that the MPC expects annual average GDP changes of -4.0% in 2009, 1.1% in 2010 and 2.7% in 2011 in its central case based on market interest rate assumptions. However, its mean projections – taking into account a negative risk skew – are much weaker, at -4.2%, -0.2% and 1.6% respectively. This looks excessively gloomy – see last post.