Inflation falls to five-month low
The rate of inflation fell to a five-year low last month, according to official figures.
Economists were expecting the Consumer Prices Index (CPI) - the official measure of the cost of living - to fall from 1.6% in August to 1.3% in September. However, significantly lower energy bills and food prices compared to the same month the previous year meant inflation fell to a rate of just 1.1% last month - its lowest level for five years.
The Bank of England is responsible for ensuring inflation remains within 100 basis points of its 2% target. If CPI falls below 1%, the central bank's governor Mervyn King will be forced to write a letter of explanation to chancellor Alistair Darling.
Jonathan Loynes, chief European economist at Capital Economics, says the sharper-than-expected fall in the rate of inflation means the UK economy is still "pretty subdued". This is despite action taken by the Bank of England to kick-start the economic recovery - namely, the record-low interest rate and quantitative easing (the creation of new money).
"Ordinarily when governments print money, sell bonds, nationalise banks and go on an enormous ‘quantitative easing’ spree, the eventual outcome is inflation," says James Hughes, chief economist at Black Swan Capital Wealth Management.
“However, the UK’s problems - comprising a massive budget deficit, ageing population, unsustainable welfare system and uncompetitive exchange rate - are so deep and fundamental that the increased money supply is not yet feeding through to prices, and may not do so for some time."
Meanwhile the Retail Prices Index (RPI), which includes mortgage costs, dropped to -1.4% from -1.3% the previous year.
The figures have prompted sterling to plummet to a six-month low against the euro.
Hughes adds: "The inevitable inflation may not arrive until sterling weakens further and the rest of the world economy starts to recover rather more impressively."
Loynes, however, expects the downward pressures on inflation to fade over the coming months, meaning CPI will move back to - and probably beyond - the 2% target at the turn of the year. VAT is due to return to 17.5% at the start on 2010, which will also help bring inflation back to target.
However, he admits that there is still a risk that core inflation could turn negative: "The downward pressure of the huge amount of spare capacity in the economy should eventually push it down sharply, keeping alive the threat of a period of outright deflation late next year or beyond."
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.
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.
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).
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.
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).