Shock surge in inflation
The Consumer Prices Index (CPI) jumped from 1.9% in November to 2.9% in December to record its largest jump in the annual rate since records began in 1997 - and well above consensus estimates of 2.6%.
It now stands at a nine-month high, pushed up by the unfavourable base effects resulting from the temporary VAT rate of 15% and oil prices falling sharply in December 2008. Lower levels of discounting by retailers in December 2009 compared to a year ago also contributed to the rise.
Meanwhile, the Retail Price Index (RPI) - which includes housing costs - also climbed sharply, up from 2.1% in November to 2.4% in December 2009.
Economists say the latest inflation figure comes as “a very nasty shock”. Core inflation, which excludes volatile energy and food prices, increased to 2.8% over 2009 despite the UK experiencing the longest and deepest recession since the Second World War.
They expect that inflation will rise further – well above the Bank of Engand's November forecast of 3% - following the return of VAT to its 17.5% level in January.
Howard Archer, economist of IHS Global Insight, warns that inflation could now take longer to fall towards the central bank’s medium term 2% target.
He explains: “While the Bank of England has indicated that it will look through the near time spike up in inflation and will focus on price prospects over the longer-term, it must be worried by the nasty December data.
“Indeed, the December inflation data not only make it even more likely that the Bank of England will call a halt to its quantitative easing programme at its February meeting (particularly as the economy seemingly returned to growth in the fourth quarter of 2009), but also increase the risk that the central bank could start raising interest rates well before the end of 2010."
But Azad Zangana, European economist at Schroders, adds: “While the latest inflation estimates are a surprise, we do not expect the Bank of England to panic and raise interest rates. This should spell the end of quantitative easing in February, but worries over growth and rising unemployment will keep the monetary policy committee in ‘wait and see’ mode for some time.”
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.
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).