Inflation starts to head lower (probably)

The rate of consumer price inflation fell to 4.8% in November, down from 5.0% in October (see Graph 1), according to figures (pdf) released today by the Office for National Statistics.

Graph 1:

Retail price inflation, meanwhile, dropped to 5.2% from 5.4%.

The recent track record of mainstream forecasters (as collated by the Treasury and published on its website) has not been good when it comes to inflation.

A year ago they expected consumer price inflation in the fourth quarter of this year to average 2.8%; today’s data suggest an outturn of 4.8% – two full percentage points higher. This is a massive miss in forecasting terms. By this time next year, the same forecasters expect inflation to have fallen back to 2.2% (and the Bank of England and the Office for Budget Responsibility take a similar view).

Should we believe them?

For roughly a decade between 1996 and 2006, forecasting inflation in the UK was a doddle. Domestic inflation pressures were muted and there were few external shocks, and those that did occur were relatively small. Inflation stayed close to its target rate.

However, the last five years have seen a series of larger external shocks, particularly as a result of volatile oil and food prices. As these are largely unpredictable, so UK inflation has become almost impossible to forecast with any degree of accuracy.

Economists got their 2011 inflation forecast wrong because they did not predict the price of crude oil would increase from $75 a barrel in September 2010 to $125 in May 2011, with consequent effects on petrol and domestic energy prices.

Whether their projection for 2012 proves to be right or not will depend, to a large extent, on what happens to the oil price over the next 12 months. If it continues to drift sideways, as it has done for much of the last six months, then inflation probably will fall back to close to its target rate; if it moves sharply higher (or lower), then inflation forecasts will turn out to be embarrassingly wrong again.

What happens to inflation matters for a number of reasons. Lower inflation will ease the squeeze on households’ real incomes (assuming wage increases are maintained at roughly the current rate). This might be expected to lead to stronger growth in consumer spending and in economic growth (though what happens in the eurozone will probably turn out to be even more important in this respect).

This will affect the nature of the political debate about the economy.

The opposition are on the front foot at the moment, claiming the paucity of growth in the UK is evidence that the coalition’s policies are not working. If oil prices had stayed at $75 a barrel throughout the last year and inflation was currently 2.8% not 4.8%, then growth would be stronger and the opposition’s arguments weaker.

It is quite possible the combination of lower inflation in the UK and muddling through in the eurozone will lead to some sort of economic recovery as 2012 progresses. If it does, and if it is strong enough to at least halt the rise in unemployment, then the opposition is going to need some new arguments.

See also:

• Economic update, December 2011 – UK teeters on brink of recession – Tony Dolphin, December 5th 2011

• Osborne proved the doommongers wrong – the economy is even worse than we predicted – George Irvin, November 30th 2011

• When does economic growth benefit people on low to middle incomes – and why? – James Plunkett, November 21st 2011

• High inflation + high unemployment = misery, misery, misery… – Tony Dolphin, November 16th 2011

• Inflation is worse for the worst off – Alex Hern, November 6th 2011