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Inflation higher than expected, but is it good news?

The consumer price index (CPI) for July was 1.8%, which was exactly the same as it was in June, and remained within the government’s 2% target. The CPI saw some downward pressure on prices from food, soft drinks, restaurants and hotels but these offset by rises in the prices of games, toys, hobbies and recorded media such as DVDs and computer games.

 

At the same time, the Retail Prices Index (RPI), which includes housing costs such as mortgage interest payments, actually increased, whilst still remaining negative. It rose from -1.6% in June to -1.4% in July. In other words it showed that prices were still falling but a decreasing rate.

 

The latest trend is shown in the figure below.

Source: ONS

Source: ONS

 

Even more interesting was the fact the “core inflation” which removes more volatile costs such as energy and food prices, rose from 1.6% to 1.8%. Many economists regard the “core inflation” figures as being a strong indicator of basic trends within the economy.

 

So what does it all mean? To some degree it could be considered good news. If prices are remaining “sticky” in general, it may suggest that there is more demand within the economy than previously thought, and that this may be a good marker that we are moving out of recession. After all, the CPI figure for the EU was 0.6% in June compared to the UK’s 1.8% and Germany and France both moved out of recession in the second quarter.

 

At the very least it suggests that deflation is not going to be a problem for the UK. In fact, it casts doubt on the Bank of England’s prediction that CPI inflation would fall below 1% later in the year. We would expect inflation to start to rise again in 2010 as the government reverses its reduction in VAT, and raises it back up from 15% to 17.5% next January. Also, earlier cuts in energy bills, mortgages and other products will start to fall out of the annual index, which will increase the various measures of inflation.

 

Prices have been boosted by the fall in the sterling exchange rate which is still 20% below what it was in 2007 and has made imports more expensive. But sterling has been rising in recent months and if this continues will have a downward impact on prices going forward.

 

So, inflation is not falling as quickly as anticipated, or as quickly as it has in other countries. There are signs of upward pressures in prices but also the possibility that they may have further to fall. All of this increases the pressure on the Monetary Policy Committee to work out just how much upward pressure there is in the economy at the moment and if, or when, they will need to tighten monetary policy by raising interest rates. If they get it wrong, they could send the economy tumbling back into a further recession.

 

 

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Posted in Bank of England, Inflation, Interest rates, sterling

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