The fall in annual consumer price inflation from 3.2% in June to 3.1% in July reflected a larger decline in the "core" rate – excluding energy, food, alcohol and tobacco – from 3.1% to 2.6%, offset by a rise in food inflation from 1.7% to 3.0%. The core number was a favourable surprise but the impact on the near-term inflation outlook is offset by the likelihood that food price rises will remain stronger than previously expected, given recent increases in raw commodity costs.

Incorporating today's figures, CPI inflation is projected to ease back below 3.0% over coming months before moving up to this level again in early 2011 as the standard VAT rate is raised to 20% – see chart. This implies that Bank of England Governor Mervyn King may avoid having to write a fourth explanatory letter to the Chancellor this year. The VAT hike is expected to boost annual inflation because consumer-facing companies are expected to pass on a greater proportion of the 2.5 percentage point increase than for the identical rise in January 2010, partly because the latter was a reversal of a previous cut.

The Bank of England's modal forecast in the August Inflation Report is similar to the profile shown in the chart until next spring but the Bank then expects a sustained decline to below the 2% target in 2012. This is partly explained by the mechanical effect of the VAT rise dropping out of the annual comparison but the Bank is also assuming a significant fall in core inflation as a lagged consequence of the large-scale spare capacity it believes was created during the recession. The view here remains that the Bank is overplaying the excess capacity argument – the "output gap" is probably no greater than 2% of GDP – while core inflation will be underpinned by a continuing economic recovery, further upward pressure on import prices (barring a strong rebound in sterling) and an upward drift of inflationary expectations resulting from the current prolonged overshoot.