The smaller-than-expected fall in UK annual consumer price inflation in May partly reflects the continuing after-effects of sterling's plunge during 2008, discussed in earlier posts (e.g. here). With the exchange rate recovering recently, however, inflation prospects are improving, although the MPC's forecasts are too optimistic.

Headline CPI inflation edged down from 2.3% in April to 2.2% in May but remains above target and would be significantly higher but for December's VAT cut. Assuming retailers passed on half of the VAT reduction, "true" inflation is probably 2.7-2.8%. (The CPI at constant tax rates shows a larger rise, of 3.3%, but assumes unrealistically that the cut was passed on in full.)

As well as the VAT change, slowing food and energy prices have contributed to the recent decline in the headline rate. Core trends, however, remain sticky: the annual increase in the CPI excluding unprocessed food and energy moved up from 2.0% in April to 2.1% in May and would be an estimated 2.7% without the VAT reduction (again assuming 50% pass-through).

The impact of the lower exchange rate is evident in less favourable price trends for such categories as clothing and footwear, audio-visual goods and package holidays. Currency weakness has also reduced the benefit of lower global commodity prices: a 7.8% annual rise in the UK CPI for food and non-alcoholic beverages in May compares with an increase of just 0.3% in the Eurozone.

Sterling's recent rally, however, will curb import price pressures. The chart shows annual rates of change of manufactured import prices and the effective exchange rate, plotted inverted. Import cost inflation has already slowed from an annual 15% in December to 10% in April and prices are likely to fall later in 2009 if the effective rate remains at its current level.

The MPC appears once again to have underestimated current-quarter inflation in its latest Inflation Report: the 2.25% April / May average compares with a central projection of 1.9%. The MPC was forecasting a fall to just 0.4% by the fourth quarter but is likely to revise this up in the August Report, reflecting recent higher-than-expected outturns, better economic data and higher oil prices.