There are two main measures of inflation, namely the Consumer Prices Index (CPI) and the Retail Prices Index (RPI). The main difference between CPI and RPI is that the latter includes mortgage interest payments and housing costs.
Inflation in the UK has been highly topical in recent months due to the sharp rise in both the CPI and RPI rates. April saw CPI reach its highest level in seventeen months as the inflation rate hit 3.7%, which is significantly higher than the Bank of England target rate of 2% and is also the highest level since November 2008. The RPI rate also rose sharply, reaching 5.3%, its highest level in nineteen years.
According to The Office of National Statistics (ONS), food prices have risen particularly sharply owing to rising transport costs during the last twelve months. In this respect, fuel costs have risen by over 25% during this period. Following April's budget, the resulting higher duty on alcohol and cigarettes added to inflation while there was also a large increase in clothes prices.
As a result of CPI remaining over 1% above the 2% target rate, the Bank of England Governor, Mervyn King, has had to write an open letter of explanation to the new Chancellor, George Osborne. In his letter, Mr King commented that inflation had accelerated significantly since September last year for a number of reasons, namely rising fuel prices, the rise in VAT and the fall in the value of sterling, which made imports more expensive.
Mr King also warned that he believed that these temporary factors were "masking the downward pressure on inflation from the substantial margin of spare capacity in the economy". He also added that: "If the recovery continues as expected, that will gradually erode the slack in the economy, bringing inflation back to target."
One of the main concerns of late has been the fact that the Bank of England's forecasts have been so different to the actual current level and whether it has been too relaxed about inflation, particularly as it has been consistently above expectations for much of the last twelve months. However, the minutes from the most recent Monetary Policy Committee (MPC) meeting, together with the latest quarterly inflation report released earlier this month, show that the Bank of England has changed its views.
In its latest quarterly report, the Bank of England revised up its inflation forecast for the second quarter from February figure of 2.8% to 3.3%. Furthermore, the minutes indicated that the spare capacity in the economy might not be having as great an impact on inflation as originally believed. As a consequence, some members of the MPC have expressed concerns about the persistently higher level of inflation, although none have yet to vote for an increase in interest rates.
The high rate of inflation has also led to increasing comments regarding an interest rate increase sooner rather than later, particularly if it does not fall back quickly and the possible threat of a further VAT increase could also hamper any such decline. The Organisation for Economic Co-operation and Development (OECD) has recently stated that it as inflation remains so much higher than the 2% target, the Bank of England could begin to lose credibility if it doesn't start lifting rates and certainly by the last quarter of this year.
However, the Bank of England will be mindful that the current very low interest rates are required to help the economy recover from the recent severe recession. In addition, the belief that the current high rate of inflation is only temporary and that it is still expected to start to fall once the upward pressures start to fall away, particularly once the impact of higher oil prices and weaker sterling drop out of the annual calculations. Finally, the strong likelihood of significant government spending cuts could also have a slowing impact on the economy and, therefore, inflation in the second half of this year and early-2010.
Richard Wallis is head of research & investment at Origen
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