Bank of England Governor Mervyn King and other MPC members continue to claim that the current inflation overshoot reflects transitory factors including the weak exchange rate and higher global energy prices, while underlying inflationary pressures are weak. This is not supported by a national-accounts-based measure of domestic inflation.

The “implied deflator for gross value added at basic prices” measures the domestic cost – in terms of wages, profits and rents – of producing a unit of output. It excludes, by construction, indirect taxes and import prices, including the cost of imported energy and other commodity inputs. The GVA deflator rose by 2.5% in the year to the second quarter and by an annualised 3.2% in the latest six months. 

These numbers probably understate domestic inflationary pressures because the GVA deflator implicitly assumes that the recent VAT rise was passed on in full to buyers of goods and services. In practice, part of the increase will have been absorbed by suppliers in the form of lower wages, profits or rents. The deflator for GDP at market prices – which adds in indirect taxes – rose by an annual 4.1% in the second quarter. Assuming 50% pass-through of indirect tax changes, the annual GVA deflator rise would have been 3.3% rather than 2.5% in the second quarter if VAT and other rates had remained stable (i.e. the average of 2.5% and 4.1%).

The annual increase in consumer prices has averaged 0.6 percentage points less than that of the GVA deflator since the MPC’s inception in 1997 (i.e. 1.8% versus 2.4%). This shortfall, however, partly reflects falling import costs in the late 1990s and early 2000s due to globalisation and sterling strength. With import prices now adding to, rather than subtracting from, domestic pressures, a rise in the GVA deflator of 2.5% per annum or more is likely to imply a continued overshoot of the 2% CPI inflation target.