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Economic issues: Inflation update

The rate of inflation remains a significant problem for policymakers at the Bank of England (BoE), and their headache is unlikely to abate. Their dilemma centres on the need to bring inflation under control without derailing Britain’s fragile economic recovery.

By Richard Eastwood, IFA at Pearson Hinchliffe Solicitors & Financial Services LLP.

UK Consumer Price Inflation (CPI) remained static at 3.1% year on year during August, according to the Office for National Statistics (ONS), after falling for the previous three months. Month-on-month, inflation rose by 0.5% during August, having fallen by 0.2% during July.

Inflationary pressures have been exacerbated by higher prices for clothing and footwear, food and, in particular, air travel. Air fares experienced a record rise of 16.1%, underpinned by seasonal demand.  Meanwhile, food prices registered an increase of 4.1% over the year. The price of wheat has posted a particularly sharp rise in the wake of fierce drought in Russia and devastating floods in Pakistan  Elsewhere, retailer Primark recently warned that the clothing industry faces pressure from the rising costs of raw materials and shipping, and from the scheduled rise in VAT in January 2011.

While CPI remained at 3.1% in August, growth in average earnings (excluding bonuses) in the year to August 2010 was 1.5%, indicating that UK wage earners’ ability to spend is not keeping pace with rising prices. Looking ahead, concerns about public sector cuts, higher taxes and unemployment are likely to increase caution amongst consumers, and sentiment was not improved by the news that retail sales posted their first monthly decline since January during August.

UK inflation remains well ahead of the BoE’s government-set target of 2%, and has stayed above target since December 2009, fuelling speculation that the Monetary Policy Committee (MPC) will be forced to increase interest rates rather sooner than expected. Interest rates have remained at their all-time low of 0.5% since March 2009, and an increase in rates would prove controversial amid stringent cuts in public spending and a fragile economic recovery.

In July’s Quarterly Inflation Report, the BoE warned that inflation is likely to remain above target until the end of 2011, underpinned by higher VAT, rising energy costs and the effects of a weak pound.  In the short term, BoE policymakers believe that the risks to UK inflation lie on the upside. Looking further ahead, the BoE believes that inflation will eventually subside below 2% during 2012 as spare capacity continues to affect companies’ costs and prices.

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