UK Inflation Falls to 4.1%

Inflation fell sharply last month on the back of falling petrol prices but it remains far above the government’s target, forcing Mervyn King, governor of the Bank of England, to write another letter on Tuesday explaining why inflation remains so high and what the Bank is doing to bring it down.

The letter comes at an odd time, as the Bank and economists expect inflation to drop extremely sharply in coming months and Mr King said it was quite possible” that he would be required to pen a letter sometime in 2009 explaining why inflation was too low.

Under the remit governing Bank of England independence, the governor and the chancellor exchange letters when inflation moves more than one percentage point away from its 2 per cent target, and must repeat the exercise every three months if the deviation from target is persistent.

The Office for National Statistics reported on Tuesday that consumer price inflation had fallen to 4.1 per cent in November from 5.5 per cent in October and a peak of 5.2 per cent in September.

The drop was a little more modest than economists had expected, but has not changed expectations of a rapid decline in inflation rates as energy prices start to fall in coming months and last year’s rise in food prices fall out of the annual comparison.

In his letter, Mr King emphasised the volatility of commodity and food prices in driving inflation, first way above target this year and likely to plunge it well below target next year.

For 2009, he added that lower commodity prices would bring down petrol, gas and electricity prices, the recession would decrease the ability of companies to pass on cost rises to consumers and the pre-Budget report’s cut in value added tax would all depress inflation in the year to come. In 2010, the reversal of the VAT cut would then raise inflation again.

In response to all these one-off shocks to prices, the Bank committed itself to look through the temporary effects on inflation, and focus on ensuring that inflation remains on track to meet the 2 per cent target once the direct effects of the VAT change drop out of the annual inflation measure in early 2011”.

It added that a substantial risk has emerged over the past three months that inflation will undershoot the target in the medium term,” concluding that the risk of low inflation would persist for a while” necessitated the 3 percentage point cuts in interest rates over the past three months.

Many analysts expect the inflation rate to turn negative in 2009 as the recession bites ever deeper. Jonathan Loynes of Capital Economics said: November’s UK CPI figures are another step along the path which is likely to lead to the first bout of deflation in the UK economy for almost half a century”.

One reason inflation might stay low for a long time is that the public’s expectation of future inflation rates are falling away very sharply. On Monday, the Citi/YouGov December inflation expectations survey for the year ahead fell to a record low of 0.8 per cent in a series that began in late 2005. Long-run expectations for CPI were also at the lowest on record at 2.8 per cent compared a previous low of 3 per cent.

Most observers expect inflation, as measured by the retail price index, to fall below zero in 2009, because it includes variable rate mortgage interest payments and house prices, both of which are falling fast. The RPI inflation rate in November dropped to 3 per cent, down from 4.2 per cent in October.

The ONS said that it might have to delay next month’s inflation figures because the collection of the data has been made more difficult by the VAT cut, which is being applied at the tills and not on price labels in many shops.

UK Inflation Falls to 4.1%, Financial Times
12/16/2008 5:16:05 AM