King sees sharper decline in inflation ahead for UK

The first signs that inflation in the UK has reached its peak emerged on Tuesday after estimates showed CPI fell to 5% in October, raising concerns that inflation may now undershoot its target in 2012.

According to the Office of National Statistics (ONS), CPI inflation in the UK fell from 5.2% in September, to 5% in October, following a decline in the cost of food due to significant and widespread discounting by supermarkets and good harvests. However, the ONS said this was partially offset by upward pressure from increases in the cost of clothing, electricity and gas.

Although inflation fell for the month, it still remains well above the Bank of England's 2% inflation target, prompting Mervyn King, its governor, to send a letter to chancellor of the exchequer, George Osborne, explaining why inflation was so high.

In the letter, King said the current high level of inflation reflected temporary factors, including the increase in the VAT rate and previous steep increases in import and energy prices. He said that as the impetus from external price pressures dissipates, the Committee's best collective judgement was that inflation would "fall back sharply in the next six months or so, and continue falling thereafter to around target by the end of next year."

He said that while he was confident about the direction of change of inflation over the coming months, there remained some uncertainty over the precise pace and extent of the drop in inflation, adding that it was possible inflation could fall back more sharply considering the existing margin of spare capacity in the economy, given the substantial risks around the global economic recovery. "It could fall back more slowly if companies attempt to restore profit margins by raising their prices, there is significant further pass-through from previous increases in import prices, or the sustained period of above-target inflation becomes embedded in wage and price-setting behaviour," he said.

Vicky Redwood, a chief UK economist at consultancy Capital Economics, based in London, says that while it is too soon to declare decisively that inflation has passed its peak, it is expected to fall sharply. "As last year's VAT increase drops out of the annual rate, inflation should plummet in January. And as energy effects also fade, we think inflation should be back to 2% by September," says Redwood, adding that the MPC's main problem now will be how to avoid "undershooting" its target further in the future.

Inflation in the UK has been more than one percentage point above the 2% target for the past 22 months, and hit a record high 5.2% in September. The following month, the Bank's Monetary Policy Committee (MPC) voted to increase the size of its asset purchase programme by £75 billion ($118 billion), to £275 billion. The Bank's MPC has long argued that inflation was likely to rise above 5% in the near-term, before falling back sharply in the first part of 2012 as base effects from both the earlier VAT increase and higher oil prices dropped out of the 12-month comparison.