Inflation adds to the UK’s economic worries

News that UK inflation (as measured by the consumer prices index) eased back to 3.2 per cent in June, from 3.4 per cent in May, merits only the smallest of cheers.

The fall – which was largely the result of lower petrol prices – was a little less than expected by City economists, and the core inflation rate, which excludes volatile elements such as seasonal food prices and fuel prices, actually rose to 3.1 per cent – its joint-highest rate since records began in 1997.

This rise in the core rate will be of particular concern to inflation hawks, such as Andrew Sentance, the Monetary Policy Committee member who has already voted for an increase in interest rates. Mervyn King and the majority of his colleagues are sticking for now to the view that high inflation is the result of special factors: January’s increase in VAT, sterling’s weakness in 2008 and high global oil prices. But every month that inflation remains well above its target rate of 2 per cent, there is a risk that more MPC members will defect into the Sentance camp.

It will seem ridiculous to most people that the MPC could contemplate an increase in UK interest rates at a time when the economy is limping out of recession, unemployment is hovering around 2½ million (and is expected to increase further when public spending cuts begin to bite) and the mini-revival in the housing market has run out of steam. But the MPC will worry that high recorded inflation rates lead to an increase in inflation expectations so that, eventually, higher inflation becomes ‘locked-in’ and very hard to reduce.

Higher interest rates would be particularly bad news for the Chancellor. His budget is predicated on the view that early and large cuts in government borrowing will allow interest rates to remain low, supporting a strong recovery in private sector demand. The effect on confidence of an early increase in interest rates would expose a fatal flaw in his calculations.

One of the credit rating agencies – Standard & Poors – warned yesterday that economic growth in the UK would undershoot the assumptions underlying the Budget, causing debt to reach a level incompatible with an AAA rating, something the Chancellor has staked his reputation on maintaining.

But there is already a very real risk that large spending cuts will weaken the economy to the point where they become self-defeating when it comes to reducing government borrowing – because they will lead to lower tax revenues and higher spending on out-of-work benefits.

Every month that inflation disappoints and the prospect of an increase in interest rates gets a little nearer, adds to the risk of a downward spiral of weak economic growth and further spending cuts as the Chancellor tries desperately to fulfil his commitments on government borrowing, irrespective of the economic circumstances.