CPI inflation rose from 4.0% in January to 4.4% in February, above the consensus forecast of 4.2% but in line with the projection made in a post a month ago. The chart presents an updated profile for 2011 and 2012, based on the same assumptions as in the prior post. Inflation is forecast to fluctuate in a 4.2-4.5% range over the summer and autumn before subsiding from late 2011 as base effects turn favourable. It remains well above the 2% target in 2012, however, averaging 2.5%.
Risks to this forecast are judged to lie on the upside. In particular, the assumption that core prices (i.e. excluding energy and unprocessed food) increase at a 2.25-2.5% annualised pace may prove too low, based on recent evidence that inflation expectations are becoming detached from the target. Further increases in energy and food prices, of course, are also possible.
With February's 4.4% outturn projected to be repeated in March, inflation is on course to average 4.2-4.3% in the first quarter – above the Bank of England's forecast of 4.1% in the February Inflation Report.
Doves claim that inflation would be below target but for indirect tax rises and higher food and energy costs. The Office for National Statistics estimates that full pass-through (unlikely) of tax increases would have boosted the CPI by 1.7 percentage points over the last year. Above-average rises in food and energy prices arithmetically account for a further 1.1 percentage points of current inflation.
Subtracting these effects from the 4.4% headline rate to argue that "true" inflation is below 2%, however, is intellectually flawed. Had taxes remained stable and food and energy prices risen more modestly, consumers would have had more cash to spend on other goods and services, the prices of which would have increased correspondingly faster.
The fundamental cause of above-target inflation has been strong growth in nominal demand, in turn reflecting excessively loose monetary conditions. "Gross final expenditure" – domestic consumption and investment spending plus exports – rose by a nominal 7.2% in the year to the fourth quarter of 2010 and would have increased by nearly 8% but for December's bad weather. This compares with average expansion of 5.5% per annum in the first 10 years of the MPC's existence (i.e. between 1998 and 2007).
Recent evidence confirms that the prolonged inflation overshoot is feeding through to longer-term expectations and pay settlements. The median level of settlements in manufacturing and private services was 2.9% in the three months to January, according to Incomes Data Services, a level that, if sustained, suggests a pick-up in private-sector regular earnings growth from an annual 2.1% in January to 3.6% by the end of 2011 – see previous post. Faster labour cost expansion could push core inflation higher in late 2011 and 2012 even as imported inflationary pressures ease.