Recent rises in global food commodity prices may lift annual CPI food inflation to about 7% by late 2010, from 1.7% in June, implying a boost of half a percentage point to headline CPI inflation. If food costs continue to spike, CPI inflation could reach 4%. Such an increase would hit consumer spending and recovery prospects and could destabilise inflationary expectations. This could warrant postponing or cancelling the coming VAT hike.
The Food and Agriculture Organisation (FAO) food index – a monthly measure covering meat, dairy products, cereals, oils and fats, and sugar – rose by an annual 22% in sterling terms in August, the fastest rate of increase since September 2008. Food prices have increased further in September: the Commodity Research Bureau daily spot food index is currently 7% above its August average, again in sterling terms.
Consumer food prices have already started to respond to these cost rises. Annual CPI food inflation increased from 1.7% in June to 3.0% in July (August figures are released on Tuesday). The historical relationship with the FAO index suggests a further rise to about 7% by late 2010 – see chart.
Rising pressures are confirmed by today's producer price numbers, with annual input cost inflation in food and beverages manufacturing rising from 3.2% in July to 4.6% in August. The British Retail Consortium's (BRC) shop price survey, meanwhile, showed a rise in food inflation from 2.5% to 3.8% between July and August.
In its August Inflation Report, the Bank of England forecast headline CPI inflation of 3.2% in the fourth quarter (mean projection). The Bank may have assumed that food inflation would remain at about 2% – the June reading of 1.7% was the most up-to-date when the Report was prepared. If so, a rise to 7% would boost the Bank's fourth-quarter forecast by half a percentage point, to 3.7%, given food's 9.6% weight in the CPI basket.
If a further food commodity price spike pushed CPI food inflation up to an annual 10%, the headline CPI rate could reach 4%. (10% food inflation would be below the peak of 14.5% reached in August 2008.)
Such an increase would damage recovery prospects by squeezing real income and money supply expansion. It would also risk destabilising inflationary expectations, particularly if the MPC were thought likely to respond to renewed economic weakness by restarting asset purchases.
A preferable policy response would be to postpone or cancel the VAT rise, thereby cutting headline inflation in early 2011 by about one percentage point. This could be justified partly by recent better-than-expected public sector borrowing numbers, suggesting that the 2010-11 total will undershoot the OBR's £149 billion forecast by at least £10 billion – the VAT increase is estimated to raise £12 billion in 2011-12.
