Surprise fall in inflation puts pressure on pound

Oct 14 2009 by Iain Laing, The Journal

INFLATION sunk faster than expected to hit a five-year low last month at 1.1% - down from August's 1.6% - as hikes in household energy bills in 2008 compared with unchanged bills for the same month this year.

The fall to CPI’s lowest level since September 2004 caught economists by surprise and put further strain on the pound, which edged another step closer to parity against the euro.

The fall is likely to give the Bank of England extra room to manoeuvre as it considers whether to extend its quantitative easing programme from £175bn. Interest rates are already at a record low of 0.5%.

However, experts warned of inflation rises, particularly given the impact of last year’s VAT discount, which will be removed in January.

David Page, an economist at Investec Securities, said CPI in September was much weaker than the market’s expectation of 1.3%.

But he said across the year inflation had been unexpectedly resilient and predicted the rise in VAT from the current rate of 15% to 17.5% in January could cause the measure to jump to 3% - well above the Bank of England’s 2% target.

He said: “Despite the bigger-than-expected drop in inflation this month, we have been surprised how little inflation has declined this year,” he said. We think that the sharp drop in sterling, rising second hand car prices, firmer-than-expected oil prices and sticky utility tariffs have all contributed to a more persistent rate of inflation than we expected.”

The official figures were dominated by the effect of gas, electricity and other fuel prices, which slumped to minus 7.3% in September from a positive rate of 4.2% in August. It is the lowest figure since the ONS measure began in 1997.

The housing and household service sector, which includes energy prices, fell to minus 1.1% across the month, also the lowest figure on record.

Food prices fell 0.9% between August and September, its largest decline across those two months since 2006.

Transport remained the biggest upward contributor in the month, as the average price of petrol increased by 2.4p per litre to 106.2p, compared with a fall of 1.7p a year ago.

Second-hand car prices also rose compared with a year before, but the rises were partially offset by sea and air transport, where seasonal price reductions were lower than a year ago.

The wider Retail Prices Index measure, which includes house prices and mortgage interest, has been negative for much of the year.

Lower mortgage interest payments have kept the measure below zero.

Howard Archer, chief UK and European economist at IHS Global Insight, said today’s figures reinforced his view that the Bank will keep interest rates at 0.5% well into 2010.

And David Kern, chief economist at the British Chambers of Commerce (BCC), said the lower-than-expected figures would allow the Bank’s Monetary Policy Committee to provide extra stimulus without worrying about a short-term spike in inflation.