Annual consumer price index (CPI) inflation surged to a much higher-than-expected nine-month high of 2.9% in December from 1.9% in November and a five-year low of 1.1% in September, according to the Office for National Statistics (ONS). CPI inflation had previously trended downwards to the September 2009 level from a peak of 5.2% in September 2008 (which had been the highest rate since the series started in January 1997). The Bank of England is mandated by the government to keep CPI inflation within a one-percentage-point band around a central 2.0% target level. Consequently, inflation in December moved substantially back above the target rate following six months of below-target inflation. Furthermore, it looks certain that Bank of England governor Mervyn King will have to write an open letter to Chancellor (Finance Minister) Alistair Darling in February to explain why consumer price inflation in January rose more than one percentage point above its target level and what the Bank of England is doing about it.

Base Effects and Reduced Discounting Push Inflation Up

The marked downward trend in consumer price inflation over the year through to September 2009 was primarily the consequence of the sharp fall in oil prices in the latter months of 2008 and the early months of 2009 from their July 2008 peak levels of around US$147/barrel. This led to a reduction in utility bills and caused transport prices to moderate. Although oil prices firmed markedly from their early-2009 lows under US$40/barrel to around US$80/barrel in the final months of 2009, they remained significantly lower year-on-year (y/y) through to September. In addition, inflation was brought down by a waning of the upward pressure from food prices, greater discounting on the high street as retailers tried to persuade pressurised consumers to part with their cash, and the government's decision to cut value-added tax (VAT) from 17.5% to 15.0% in December 2008 as part of a fiscal stimulus package designed to boost the economy.

The spike in consumer inflation since September 2009 has primarily stemmed from unfavourable base effects resulting from the sharp fall in oil prices in the latter months of 2008. This was reflected in fuel and lubricants prices rising 18.4% y/y in December, having been down by 6.6% y/y in September. In addition, the y/y rise in transport prices spiked up to 8.7% in December from 1.2% in September as it was further lifted by higher prices for cars. Meanwhile, food prices rose 1.0% month-on-month (m/m) in December, causing the y/y increase to climb to 1.6% from 1.3% in November and 1.1% in September.

Core Inflation Jumps

Consumer price inflation was pushed up appreciably in December by the VAT cut a year earlier not being repeated. In addition, there was clearly less discounting by retailers in December 2009 compared with a year ago, when they were hugely concerned about sales prospects for the critical Christmas period as economic activity nosedived. As a result, core inflation (which excludes energy, food, alcohol, and tobacco prices) jumped to 2.9% in December from 1.9% in November, 1.7% in September, and a low of 1.5% in April 2009. The fact that core inflation did not fall lower than 1.5% despite the length and depth of the recession suggests that sterling's weakness has had a significant upward impact on prices.

Other Inflation Measures Up Sharply

Annual underlying retail price index (RPIX) inflation meanwhile jumped to an 11-month high of 3.8% in December from 2.7% in November and 1.0% in June, which had been the lowest level since the series started in January 1976. There are different weightings in the CPI and RPIX inflation measures that can lead to diverging performances at times. The latter also includes some housing-cost components, which are now rising, having fallen markedly through to the second quarter of 2009.

Meanwhile, the all-items retail price index (RPI) showed the y/y rise in prices climbing to 2.4% in December from 0.3% in November. This followed eight months of deflation on this measure up to October, peaking at a drop of 1.6% y/y in June (which had been the largest fall since the series began in 1948). All-items RPI inflation includes mortgage interest payments, which had a major downward impact as a consequence of the Bank of England slashing its key policy rate from 5.00% to a record low of 0.50% between October 2008 and March 2009. However, given that mortgage interest rates are now essentially stable—as opposed to falling a year ago—this is now having an upward impact on the all-items RPI inflation rate.

Outlook and Implications

Annual consumer price inflation is likely to climb significantly higher in the near term after surging to 2.9% in December 2009 from a five-year low of 1.1% in September. Given that oil prices fell pretty sharply throughout the latter months of 2008 and early 2009 from their July 2008 peak levels, base effects will be unfavourable over the next few months. Furthermore, oil prices are currently trading up around US$80/barrel. Inflation will also be pushed up by VAT having risen back up from 15.0% to 17.5% in January. Sterling's weakness may also continue to have an upward impact on inflation in the near term. With December's jump in inflation having been much higher than anticipated, consumer price inflation now seems set to peak around 3.5% in March/April rather than just above 3.0% as IHS Global Insight had previously expected.

However, we still believe that consumer price inflation will fall back appreciably in the second half of 2010, albeit from a higher peak level than previously seemed likely. Indeed, inflation still seems likely to fall back below 2.0% at the end of 2010 or early in 2011 as underlying inflationary pressures are limited by substantial excess capacity, extended below-trend growth, companies' limited pricing power throughout the supply chain, a likely ongoing need for retailers to price attractively to persuade consumers to spend, and muted wage growth amid high and still rising unemployment. Furthermore, sterling is expected to be firmer overall in 2010. Despite the economy seemingly having returned to growth in the fourth quarter of 2009, we suspect that the rate of expansion will not be strong enough for some considerable time to come to significantly lift underlying inflationary pressures. Indeed, we believe that consumer price inflation is likely to be below 2.0% throughout 2011 as an output gap persists and unemployment remains relatively high. Even so, we have raised our average consumer price inflation forecast for 2010 to 2.7% from the previously expected 2.2%. Inflation is still seen averaging 1.6% in 2011.

Bank of England Still Likely to Keep Interest Rates at 0.50% Until Late 2010

Although the Bank of England had forecast inflation to rise appreciably during the latter months of 2009 and the early months of 2010, December's increase was clearly well above the bank's expectations. In fact, consumer price inflation averaged 2.1% in the fourth quarter of 2009, compared with 1.85% forecast by the Bank of England in its November Quarterly Inflation Report. With VAT having now risen back up from 15.0% to 17.5%, it is evident that consumer price inflation will peak at a significantly higher level in the early months of 2010 than the 3.0% forecast by the Bank of England back in November. The danger is also that inflation will prove to be stickier than expected and will not fall back as quickly or as far as expected thereafter.

Consequently, the December inflation data reinforce expectations that the Bank of England will call a halt to its quantitative easing programme at the February meeting of its Monetary Policy Committee (MPC), particularly as the economy seemingly returned to growth in the fourth quarter of 2009. Furthermore, the December inflation data increase the risk that the central bank could start raising interest rates well before the end of 2010. We currently still lean towards the view that the Bank of England will hold off from raising interest rates until the fourth quarter of this year, given probable persistent concerns and uncertainties about the strength and sustainability of the recovery, but the odds have undeniably shortened that the bank could move before then.

Global Insight (Reino Unido)