Inflation makes prospects for improved growth in rest of 2011 dim

The UK’s rate of inflation increased from 4.2% in June to 4.4% in July according to figures released today by the Office for National Statistics.

This was in line with economists’ expectations and inflation looks set to increase further to around 5% in the autumn as already announced increases in gas and electricity prices are implemented.

The main causes of higher inflation in July were increases in fees charged by financial institutions, particularly for arranging mortgages, and less generous discounting in the summer sales by retailers.

It is normal to see prices of items such as clothing and footwear and furniture fall between June and July, but the falls this year were smaller than those recorded in 2010, hence the rise in inflation.

 The latest figures (for March to May) show average earnings in the UK increased by 2.3% over the last year.

Average earnings growth in recent months has been relatively stable at just above 2% and recent developments in wage settlements suggest it is likely to remain around this level over the next few months.

The latest increase in inflation and will therefore add to pressures on household budgets. Moreover, if inflation does increase to 5% in the next few months, the gap between increases in earnings and increases in prices could widen to as much as 3 percentage points.

This makes it very unlikely that the pace of economic growth will pick up in the second half of the year. Retail sales volumes, which have barely increased over the last year, are likely to remain stagnant.

Meanwhile, economic growth in the Eurozone also appears to have slowed (GDP increased by just 0.1% in Germany in the second quarter and not at all in France) and this is being reflected in reduced external orders for UK manufacturers.

Despite the higher rate of inflation, the main problem facing the UK economy in the short-term is a shortage of demand caused by higher food and energy prices and the rapid tightening of fiscal policy.

This could be countered by a temporary tax cut or a boost to government capital spending accompanied by an increase in quantitative easing.

Contrary to the assertion in today’s letter from the Chancellor to the Governor of the Bank of England, there is no reason to believe a less strict fiscal tightening this year will necessarily lead to monetary tightening.

However, the Chancellor continues to rule out any change to his fiscal plans, so we will have to wait until tomorrow, when the minutes of this month’s Monetary Policy Committee meeting are published, to see if there is any prospect of more quantitative easing.