Inflation remains flat during July
A key measure of the cost of living remained stable in July, despite expectations that the rate of inflation would fall during the month.
Economists were forecasting the Consumer Prices Index (CPI) – the official measure of inflation – to fall to 1.6% in July, but this remained flat at 1.8% over the month.
Despite the rate of inflation remaining stable, CPI remains below the 2% target set by the government.
Last week the Bank of England published its inflation report, which forecast the rate of inflation would remain low for some time. In response, economists said the base rate – the official rate of interest – was also likely to remain low.
However, Charles Davis, economist at the Centre for Economic and Business Research, says today's CPI figure comes as a surprise, especially considering inflation continues to fall in the eurozone and the economic recovery seen in France and Germany.
If inflation does start to pick up in the months ahead, then the Bank of England will have to rethink its monetary strategy and potentially start to introduce base rate rises - potentially sharp ones.
Economists from Barclays Capital Research say July's CPI figure reinforces the view that the recession might not be as disinflationary as predicted. They also warn that, as a result, the Bank of England's Monetary Policy Committee (MPC) might increase the base rate sooner than previously expected.
Inflation expectations have been divided for some time; while some experts say the economic downturn means the UK will enter a period of low or even negative inflation, others believe measures such as quantitative easing (the creation of new money) will prompt a sharp increase in inflation either this year or the next.
The fact that VAT will return to a rate of 17.5% from January, plus the recovering cost of crude oil, could also push up inflation.
But Vicky Redwood, UK economist at Capital Economics, says the fact that inflation didn’t fall during July is not a sign that the UK is about to see a rise in the cost of living.
She still believes that inflation is set to remain low for some time, and also warns there remains a “serious risk” that CPI could turn negative down the line.
“We still think that inflation will fall below 1% later this year and could drop to very low, or even negative, levels in 2010 and 2011,” says Redwood. “Overall, then, these figures do little to alter our view that deflation remains a serious risk.”
The fact is, inflation does have the potential to change directions several times over a relatively short period of time. David Page, economist at Investec Securities, is penciling in a fall to under 1% over the next two months, before inflation rises back to 2%.
In terms of the impact of this on the base rate, he says: "The MPC will try to look trough this temporary volatility. We envisage a subdued inflation background over the coming years. But we also expect the MPC to start tightening policy [i.e. increasing the base rate] from early next year."
According to the Office for National Statistics, which publishes the inflation figures, falling food prices and stable costs in the restaurant and hotel sector contributed to inflation remaining stable during July.
In contrast, computer games, DVDs and CDs saw the biggest price rises during the month.
Meanwhile, the Retail Prices Index (RPI) – which, unlike CPI, includes the cost of housing – actually improved slightly during July, rising to -1.4% from -1.6% the previous month.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
Invented by a Frenchman in 1954 and ironically introduced in the UK on 1 April 1973, VAT is an indirect tax levied on the value added in the production of goods and services, from primary production to final consumption and is paid by the buyer. Its levying is complex, with a number of exemptions and exclusions. For example, in the UK, VAT is payable on chocolate-covered biscuits, but not on chocolate-covered cakes and the non-VAT status of McVitie’s Jaffa Cakes was challenged in a UK court case to determine whether Jaffa Cake was a cake or a biscuit. The judge ruled that the Jaffa Cake is a cake, McVitie’s won the case and VAT is not paid on Jaffa Cakes in the UK.
Monetary Policy Committee
A committee designated by the Bank of England to regulate interest rates for the UK. The MPC attempts to keep the economy stable, and maintain the inflation target set by the government and aims to set rates with a view to keeping inflation at a certain level, and avoiding deflation. The MPC meets on the first Thursday of each month and discusses a variety of economics issues and constitutes nine members: the governor, the two deputy governors, the Bank’s chief economist, the executive director for markets and four external members appointed directly by the Chancellor.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
This is the opposite of inflation and refers to a decrease in the price of goods, services and raw materials. Economically, deflation is bad news: the only major period of deflation happened in the 1920s and 1930s in the Great Depression. Not to be confused with disinflation, which is a slowing down in the rate of price increases. When governments raise interest rates to reduce inflation this is often (wrongly) described as deflationary but is really an attempt to introduce an element of disinflation.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.