Inflation falls to five-month low

13 October 2009

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."

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