British inflation dropped sharply in January as the effect of a rise in 2011 sales tax fell away, supporting Bank of England forecasts for a sharp easing of price pressures this year and providing some relief for cash-strapped consumers.
The decline to 3.6 per cent - its lowest annual rate since November 2010 - will reassure the BoE as it prepares to publish an update to its quarterly economic forecasts on Wednesday.
But it did not spare BoE governor Mervyn King from having to write a public letter explaining why inflation has remained well above target for the past two years, and how the BoE still expects it to fall back to target by the end of the year.
“Upward pressure from past rises in energy and import prices should dissipate further over 2012, and the margin of spare capacity ... in the economy is likely to continue to bear down on wages and prices beyond that. But the pace and extent of the fall in inflation remain highly uncertain,” Mr. King wrote.
The Office for National Statistics said consumer price inflation fell from 4.2 per cent in December, in line with economists’ forecasts and extending a marked drop from September’s three-year peak of 5.2 per cent.
Mr. King did not want to pre-empt Wednesday’s inflation report in his letter, but economists reckon the central bank will continue to predict that CPI will be below target in two years’ time, as weak growth weighs on prices.
January’s inflation reading is in line with November’s BoE forecasts for an average of just over 3.4 per cent in the first three months of 2012.
Lower inflation may also lift consumer demand, which has been a big drag on Britain’s sluggish economy, at a time when there are also major headwinds from the euro zone debt crisis and the government’s austerity program.
Those factors were reflected in a decision by credit agency Moody’s to put the nation’s prized triple-A rating on a negative outlook, though finance minister George Osborne said Britain would not stray from its debt-cutting measures.
Despite the above-target inflation, the BoE’s Monetary Policy Committee last week pressed ahead with another £50-billion of quantitative easing via gilt purchases over the next three months, in order to boost faltering growth.
Mr. Osborne approved this expansion in QE, and said in reply to Mr. King’s letter that he agreed with the BoE’s analysis that it would take time for Britain’s economy to recover from the financial crisis and past rises in energy costs.
But if the sharp fall in inflation does not continue, this may be the last bout of QE. Some policymakers expressed concerns last year about whether inflation would fall as fast as forecast once the downward effect of one-off factors faded.
“There are a couple of easy wins over the next couple of months that should ensure inflation continues to fall. What is more of a difficult question is whether we are going to see inflation continue falling over second half of the year,” said Investec economist Philip Shaw.
He and other economists are concerned that the BoE has overestimated the downward pressure on prices from slack in Britain’s economy and that this - as well as higher oil and import prices - lies behind past inflation overshoots.
The ONS said the fall in CPI was mostly due to the January 2011 increase in the standard rate of value-added tax to 20 per cent from 17.5 per cent now being fully included in annual comparisons. Other things being equal, this reduced inflation by 0.76 percentage points, an ONS statistician said.
A stabilization in petrol prices also pushed the rate of inflation in the transport sector to its lowest since October 2009, but there remained upward pressure from financial services, clothing and footwear and air travel.
Planned cuts in electricity and gas prices should put further downward pressure on inflation over the next 3 months, the ONS added.