Inflation remains flat during July

18 August 2009

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.

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.

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