The recent CPI releases reported a rise in consumer price index of 0.1% (for the month) and 4.0% annually. Chart.1 shows the ebbs and flow different measures of inflation: CPI all items, CPI excluding indirect taxes and CPI at constant taxes. The annual measures of the rate of inflation moved in unison and at similar levels up to the September 2008 inflation peak. The peak inflation coincides with announcement of VAT concession. In December 2008, the standard VAT rate was lowered to 15% from 17.5%. During the VAT concession period CPI all items that includes indirect taxes similar to VAT declined at faster rate relative to inflation measures that exclude taxes or hold taxes constant.
Chart.1 CPI and VAT
However, the pace of the CPI all items accelerated from September 2009, as the VAT concession was set to expire in December 2009. This resulted in a widening between inflation measures. As part of the deficit repair, the ConLib government raised the standard VAT rate from 17.5% to 20%. Chart.2 highlights the effect of the VAT rise on the inflation rate of goods and services. The largest impact is on energy related products, while food was the least impacted.
Chart.2 Effect of VAT
According to Mervin King in his letter to the Chancellor “….three factors can account for the current high level of inflation: the rise in VAT relative to a year ago, the continuing consequences of the fall in sterling in late 2007 and 2008, and recent increases in commodity prices, particularly energy prices. Although one cannot be sure, prices excluding the effects of these factors would probably have increased at a rate well below the 2% inflation target.” How long inflation remains at above the target rate depends on the inflation expectations of households and companies. Persistent levels of high inflation expectations may result in companies rising prices and households demanding higher wages. My tentative analysis on expectations (will be published soon) shows that household near term inflation expectations have risen. Anecdotal evidence suggests that the market expectations on the timing of the BOE rate hike have shifted. Expectations of a rate hike are sooner rather than later. This may result in a rise in mortgage rates and potentially more repossessions.