With the December rise to 3.7%, CPI inflation averaged 3.4% in the fourth quarter, representing another significant overshoot of the Bank of England's central forecasts of 3.2% in the November Inflation Report and 3.0% in August.
 
The 3.7% print was above a median forecast of 3.4%, according to Bloomberg, but in line with a projected profile for CPI inflation presented in a post last week. Inflation is now certain to move above 4% in early 2011, a prospect belatedly recognised by the consensus. Assuming no further rise in global commodity prices, the headline rate may reach 4.3% in February, remaining at or above 4% until late 2011.
 
While food and energy prices were the key upward driver in December, the Bank's forecasting miss also reflects stubborn core inflation, which continues to defy its prediction of a slowdown in response to economic slack and fading exchange rate effects. CPI inflation excluding energy, food, alcohol and tobacco firmed to 2.9%, a six-month high.
 
It has recently become fashionable to quote the tax-adjusted inflation measures, CPI-CT and CPIY, which are running well below headline inflation, at 1.9% and 2.0% respectively (up from 1.5% and 1.6% in November). CPI-CT is calculated at constant tax rates while CPIY excludes indirect taxes altogether.
 
These measures, however, understate "true" inflation because they are calculated on the assumption that indirect tax hikes are passed on in full to consumers. ONS research on the December 2008 VAT reduction from 17.5% to 15% indicated pass-through of only one-third. Assuming that one-half of the increase in VAT and other indirect taxes last year was reflected in the prices charged to consumers, inflation would now be about 2.8% had tax rates remained stable.
 
The current inflation overshoot should be viewed in a longer-term context. The consumer prices index for December was 4.4 percentage points above the level implied if the Bank of England had achieved 2% inflation since the target was switched to the CPI in December 2003, implying an average overshoot of 0.6% per annum. The RPIX measure (i.e. retail prices excluding mortgage interest costs) has exceeded the previous 2.5% inflation target by 5.3 percentage points over this period.
 
Advocates of a rise in interest rates are not "inflation nutters" but believe action is required to prevent an upward drift in inflationary expectations that would worsen the output-inflation trade-off, thereby depressing medium-term growth prospects.