The fall in annual CPI inflation from 3.0% in April to 2.8% in May represents a significant favourable surprise that further increases the likelihood of an extension of QE – probably by £75 billion – at the July MPC meeting. “Core” price momentum, however, remains above a level compatible with achievement of the 2% inflation target.

Today’s news together with recent falls in oil and gas prices imply a sizeable undershoot of the Bank of England’s near-term inflation forecast contained in the May Inflation Report. Unleaded petrol has fallen from 142.5 pence per litre in April when the Report was being prepared to 133.6 pence last week. The Bank's assumption that domestic gas and electricity prices will rise by 2.5% during the second half of 2012 now looks questionable. The forecast here is that CPI inflation will average 2.6% in the third quarter of 2012 and 2.4% in the fourth versus the Bank’s projections of 3.15% and 2.93% respectively – see first chart.

“Core” prices can be measured by the CPI excluding unprocessed food and energy. After adjusting for seasonal effects and smoothing using a three-month moving average, this rose by 2.7% annualised in the six months to May, i.e. inconsistent with the inflation target, although six-month growth has slowed from a peak of 3.1% in February – second chart.

This measure of core price momentum is assumed here to stabilise at about 2.5% annualised over the remainder of 2012. This is supported by survey price expectations balances, which are about in line with their averages over the past three years, a period during which core momentum, adjusting for the estimated impact of VAT changes, has run consistently above 2%, averaging 2.4% – third chart.